A 401(k) retirement plan allows employees to contribute from their paychecks invested in mutual funds. These investments grow tax-deferred, and withdrawals in retirement are tax-free. The plan can be traditional or Roth.
Employee salary deferrals are 100% vested immediately in a 401(k) plan, but employer-matching contributions and investment gains are vested according to a vesting schedule.
Defined Contribution Plan
Unlike defined benefit plans, which promise an employee a fixed pension at retirement based on a formula, defined contribution plans allow employees to choose their investments and assume all investment risks. Employees can contribute to the plan’s mutual funds, money market funds, annuities, or stocks.
The most common type of defined contribution plan is the 401k retirement plan, which allows participants to contribute a portion of their earnings up to a set limit each year. The employer may match a portion of the employee’s contribution, but that is not required. Other defined contribution plans include profit-sharing, stock bonuses, and money purchase plans. The latter are typically available to large companies, while 401(a) and 403(b) plans are more flexible and available to government agencies, public educational institutions, and nonprofit organizations.
Matching Contribution
A matching contribution is an additional “free money” your employer contributes to your 401(k) plan account, up to a certain percentage of your salary. Matching contributions are often considered a key recruiting and retention tool by employers. However, there is significant variation in how matching contributions are structured among plans that offer them.
Some companies may provide a flat dollar-based cap on the total employer matching contribution rather than limiting the gift to a specific percentage of employee compensation. Other employers may use a tiered match formula, where the employer matches a portion of employee deferrals at a rate up to a capped level.
Some plans include a profit-sharing component in addition to or instead of a matching contribution. These contributions are made by the company out of its profits and are based on the overall success of the business or on individual performance metrics. Employers generally allow participants to invest profit-sharing contributions in the same investment options as their regular salary-deferral contributions. Like matching contributions, profit-sharing investments are subject to a vesting program.
Pretax Deferrals
A 401(k) and other salary deferral plans allow employees to divert part of their current earnings into their retirement savings accounts on a pretax basis. Investment returns, such as dividends and interest, are taxed deferred and only included in taxable income when the employee withdraws funds from the account (generally after age 59 1/2).
Employees may choose to roll over their 401(k) balance into an individual retirement account (IRA) or other plan when they leave their employer. They will pay taxes on the pre-tax deferrals and the investment earnings in the IRA based on their tax bracket at withdrawal time.
Tax-Free Withdrawals
The 401(k) allows participants to invest part of their pay into an account with their employer. They choose from a menu of investment options, including mutual funds. The employer may match a portion of the employee’s contribution. 401(k) contributions are made pretax, and withdrawals are taxed in retirement as ordinary income. The plan may be a traditional 401(k), a Roth 401(k), or a combination. Roth 401(k)s involve after-tax contributions, which provide an upfront tax break and can reduce the investor’s current tax bracket.
The IRS prohibits early withdrawals without a penalty from a 401(k) except in certain limited circumstances, such as death, permanent and total disability, or to cover medical expenses. Other exceptions include distributions from a 401(k) for emergency personal expenses or COVID-19 (coronavirus)-related expenses. These types of withdrawals are reported on Form 8915A. You can also avoid early withdrawal penalties by rolling over a 401(k) to an individual retirement account after leaving your employer.
Investment Options
Many 401(k) plans offer a selection of mutual or exchange-traded funds. They also offer several target-date funds that automatically shift from more aggressive to more conservative allocations based on your expected retirement date. You can choose which of these funds you want to invest your contributions in, and your employer may offer additional choices for their matching contributions. However, it’s essential to understand the fees associated with your 401k investments. Even small differences in expense ratios can eat away at your returns over time.
If you leave your company before two years, you will only own half of the employer’s matching contribution to your 401(k). Once you reach three years, you become fully vested in the employer’s matching contributions to your 401(k). Some 401(k) plans allow you to choose individual stocks and bonds, which can be valuable for experienced investors with a deep understanding of the market. But most participants prefer to let someone else handle the management for them. That’s where a managed account comes in. A managed account typically recommends a savings rate based on your goals and creates an investment mix that considers other retirement accounts, such as outside IRAs.
