What is a 401k Plan and How Does it Work?
You have probably heard the term 401(k) or Roth 401(k) thrown around before. As the end of the year is sneaking up on us, now is a great time to refresh on these terms, your financial plan, and retirement plan options that might be available to you. It is also a great time to ensure you are making the most of the options available to you! A 401(k) is an employer-sponsored retirement saving and investing plan, and it is not necessarily too late to take advantage of this employer-sponsored plan (and potential employer match) before the end of the year.
So, what is a 401k exactly?
First, let’s define what a 401k plan is. A 401k plan is an employer-sponsored retirement account that allows you to put money away for your future with some tax and contribution benefits. Generally, your employer may offer some form of “matching” contribution for the money you decide to save. You may often find that for the first 5% or more of your savings, your employer will match this contribution to some degree for each dollar saved. This match is free money and an instant return on your savings!
A 401k plan also will allow your savings to be either tax-deferred or on a tax-free basis. Tax-deferred means you will contribute the funds on a pre-tax basis, and all growth is deferred until distribution, at which point they will be taxed as ordinary income. Or, your savings will be on a tax-free basis, meaning you will not receive any tax benefits upon contribution, but all the contribution and earnings will be fully tax-free on qualified distributions in retirement. It can be very natural to assume the tax-deferral method may be best as this will give you tax savings right out of the gate, but consider the long-term tax planning strategies that may make the most sense for you.
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For example, I have a client that I just started working with who had saved their entire career to the tax-deferred side of their 401k. They have accumulated a sizeable nest egg, but they also have a pension and social security income they receive. Even in retirement, they are making more than they did during their working years, and every penny they pull out of their retirement account is now fully taxable. Don’t worry; there are still some strategies we are helping them with to reposition their assets and minimize taxation, but some thoughtful planning sooner than later can make an even more significant difference!
One way that I like to look at the pre-tax vs. tax-free options is to consider whether you would rather pay taxes at first on the seeds or wait until the full harvest to pay the taxes on what may be a much more valuable sum. Now, this is very much simplifying, and the time frame you have until needing distributions plays a considerable role in this equation. Still, for many, most of their retirement accounts may be growth, not contributions, so paying taxes today to create tax-free assets in the future may be extremely beneficial.
What is a Roth 401k?
What is the maximum 401k contribution for 2021?
The maximum 401k contribution for 2021 is $19,500/year. This amount is the TOTAL employee contribution limit, and the IRS doesn’t care if this is saved towards the tax-deferred or tax-free side of the 401k. The total number is the limit regardless of how much goes into each bucket. If you are over 50, the IRS also allows for a catch-up contribution, giving you the opportunity to save an extra $6,500/year on top of the $19,500, meaning a total of $26,000. These limits are generally indexed with inflation, so you may see these maximum contributions increase over time, and this total $26,000 limit does NOT include any contributions from your employer.
How much should I have in my 401k at my age?
There is no one-size-fits-all when it comes to retirement planning. Following the general advice around savings rates and figures may leave you constantly stressed or overly confident in your retirement. You can follow the national average based on age. Still, a vast majority of Americans are struggling to live paycheck to paycheck, so it may be wise to take the time to look at your future lifestyle expectations and develop a plan designed for you specifically on savings rates and asset mark goals.
As an example, I have a client that is constantly worried about their savings rate. Although my client is far ahead of the national average, they continuously feel behind compared with friends. However, they have been working towards shorter-term goals and knocking out debt very quickly for the past few years. Just recently, they have had the ability to play offense, and their savings rate is far above what their friends are saving today. Now, they will just need some time to see the benefits of this given their particular circumstances.
When should I roll over my 401k? When can I roll over my 401k to an IRA or Roth IRA?
For the most part, as long as you are employed by the firm that offers your 401k, you must leave these assets within your current plan. However, a few triggers will allow you to be eligible to rollover your 401k to an IRA. Generally, when these triggers apply, you may be best suited to consider a rollover as you will typically find many, many more investment options to choose from. At this point, you could consider finding an advisor who could help with this rollover. Whether you work with an advisor or decide to manage your account by yourself, rolling over a 401k to an IRA will offer many of the same tax benefits but also allow for more flexibility. That is more flexibility in your investment choices, more flexibility in your ability to contribute, more flexibility in your ability to convert to Roth, and more flexibility to determine who or how the account is managed based on your preferences.
So, what are these triggers? Although there are many more, the most common triggers that lead to eligibility for a rollover include:
Separating from your employer
Retiring
When you reach age 59 and ½ (or 55 for some plans)
Internal company changes to their plan
There are many other potential triggers as well, especially as 401(k)s have become more complicated, but these are the most common.
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When you roll over a 401k to an IRA, there are no tax consequences because the account is being moved between different account types that are taxed the same way. Due to the consistency in taxation, the IRS allows this with no tax consequences. If you have pre-tax 401k monies, these will need to be rolled over to a traditional IRA, and if you have tax-free monies, these will need to be rolled over into a Roth IRA. One of the benefits of a rollover is that once you have rolled pre-tax monies to an IRA, you can also do Roth conversions if you decide that makes sense for your planning.
For example, I have a client with a significant amount of monies in pre-tax retirement plans (all of their savings). He is a workaholic, and it so happened that this year, he had a health concern and was working much, much less, leading to a much lower income for 2021. We used his turning age 59.5 to roll over a certain amount of his employer plan to an individual IRA. Once the funds were in his IRA, we could start converting a certain amount annually to minimize his long-term tax picture. This rollover allowed us to convert pre-tax 401k dollars to Roth IRA dollars while he was in a very low tax bracket to provide tax-free growth from here on out and enhance the impact he can make to his family as well.
At what age can you withdraw from 401k?
You can withdraw from a 401k any time after age 59 and ½. Depending on your plan, you may have plan-specific rules that allow for earlier distributions as well. There are also more complex planning strategies that may allow for early distributions, but generally, age 59 and ½ is when you are free to take distributions as you please (just be cautious of any tax impacts)!
If you are curious about more considerations around retirement plans, including 401(k)s, check out some more information we have on the topic below or reach out to me to discuss your plan in particular.