What is a 401(k)?
A 401(k) is a tax-advantaged retirement savings plan that an employer sponsors for its employees. The plan allows employees to contribute a percentage of their gross income to a retirement account on a pre-tax (or in certain cases, an after-tax) basis.
Contributions to a pre-tax 401(k) plan are tax-deferred, meaning they may lower your current taxable income, and can grow to supplement your retirement income later in life. You’ll eventually pay income tax on the funds when you make withdrawals in your retirement years.
One significant benefit of the 401(k) is the potential to gain from employer matching, through which your employer contributes a percentage of your salary, and is contingent on your participation. This is an opportunity to lock in “free money” towards your retirement savings.
These features make the 401(k) one of the most popular retirement plans available, with an average collective value of over $6.6 trillion invested, according to the Investment Company Institute.
401(k)s also come in Roth account form, which we will explore later in the article.
401(k) Important Features
Investing in a pre-tax 401(k) can offer immense benefits, but there are also guidelines and drawbacks.
Some of the key features to know about these types of accounts are the following:
- Tax breaks for contributions: Because your contributions are made with pre-tax dollars, you’ll gain various tax benefits. Your current income tax bill could be lowered, providing you with immediate tax savings.
- Employer matching payments: Employers may offer a matching program where they contribute a specified percentage to your 401(k) — often a specified percentage of your total compensation. These employer contributions can accelerate your savings, and for all intents and purposes, can be considered “free money”.
- Subject to Required Minimum Distributions (RMDs): At 73, employees must begin taking distributions from their account (unless they still work for the employer). RMDs are added to your taxable income in the year of distribution.
- Tax-deferred growth: The money in a pre-tax 401(k) account grows tax-deferred, and you only have to pay taxes upon withdrawal.
- Maximum annual contributions for employees: In 2023, the IRS stipulates that employees can contribute up to $22,500 per year to their 401(k) account if they are under 50. For those who are 50 and older, the limit increases to $30,000, which includes a $7,500 catch-up contribution.
- Easy Investing: A 401(k) makes it easy to stay consistent with your investments because the funds are deducted automatically from your paycheck. Since you never actually receive the money into your bank account, it’s easy to build a track record with your 401(k) savings without even realizing it.
- Total annual contribution limits: The total annual maximum contributions, including the employer contribution, are $66,500 and $73,500 for those under 50 and over 50, respectively.
What is a Roth 401(k)?
Like traditional 401(k)s, Roth 401(k)s are also employer-sponsored retirement plans, through which employees can make regular contributions and employers can offer a matching program.
However, there is a crucial difference. Unlike a traditional 401(k), with a Roth 401(k), contributions are made with after-tax money. In retirement, qualified Roth 401(k) withdrawals are tax-free.
This means you pay income tax before funds are invested in the Roth 401(k) account. There’s no tax break upfront, and you won’t reduce your current taxable income. In retirement, you can withdraw your earnings tax-free to supplement your income, which may or may not include Social Security payments.
As a result, your savings benefit from tax-free growth, and you benefit from tax-free withdrawals. Some regulations must be met to see these tax savings: you must wait until at least age 59 1/2 — and the account must be at least five years old — before you can withdraw Roth 401(k) earnings tax-free. These withdrawals are also known as qualified distributions.
Early withdrawals from your Roth 401(k) may be subject to income tax and a penalty (10%) on the earnings portion. Contributions may be withdrawn at any time since Roth contributions are made with after-tax dollars.
This rule has a few exceptions, including some economic hardship conditions the IRS outlines. You’ll have to prove you meet the exact criteria to be considered for tax- and penalty-free distributions in those situations.
Unlike a Roth IRA, a Roth 401(k) currently has Required Minimum Distributions (like a traditional 401(k)), and does not have income limits — providing earners at all income brackets with the chance to gain from a Roth account.
Note that with the passage of the SECURE Act 2.0 in 2022, Roth 401(k)s will no longer have RMDs as of 2024, but you’ll still have to take RMDs if you’ve already started taking them in a prior year.
Having both a traditional 401(k) and a Roth 401(k) can be a smart move when it comes to creating flexibility in your estate planning.
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