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What Is A 401(k) And How Does It Work?  Thumbnail

What Is A 401(k) And How Does It Work?

What is a 401(k)? It's an account type that a lot of Americans have experience with. In the first quarter of 2020, total U.S retirement assets were $28.7 trillion. $5.6 trillion of that were assets held inside of a 401(k). (https://401kspecialistmag.com/401k-assets-totaled-5-6-trillion-in-first-quarter-2020/) Meaning approximately 20% of all retirement assets are carefully positioned inside of a 401(k) account. It's also important to note that retirement assets accounted for 33% of ALL household financial assets in the United States at the end of the first quarter of last year. (https://www.ici.org/) So it isn't hyperbole to say that 401(k) accounts in the United States play a significant factor on the wellbeing, both financially and emotionally, of a large portion of the population. Because of this, it's absolutely critical for individuals to understand all there is to know about 401(k)s. 

Key Takeaways:

  • You'll learn what a 401(k) is and why it works the way it does.
  • 401(k) contribution limits. The difference between elective deferrals, matching, and after-tax contributions.
  • What the process of withdrawing from your 401(k) looks like. Tax obligations and penalties. 
  • What your options are with your 401(k) when you leave your job.
  • Roth 401(k)s. Why they are important and how they work in comparison to a Traditional 401(k)

Prefer video over the blog? We've got you covered! Watch our YouTube video to learn the basics of 401(k)s

What Is A 401(k)?

A 401(k) is a company-sponsored plan. Employers create 401(k) plans to allow their employees to make tax-advantaged contributions into their own 401(k) accounts, which sit within that company plan. The most counterintuitive aspect of a 401(k) is it's name. 401(k) means nothing. It's actually just named after a section of the U.S. Internal Revenue Code. But the power of a 401(k), specifically when used to save for retirement, is second to none. 

Employees with access to a 401(k) get to make the decision whether or not to contribute and at what dollar amount. These contributions are made through automatic payroll withholdings. Employers are oftentimes generous enough to make matching contributions into your account as well. But let's take a closer look at its real benefit, tax savings. When you make a payroll withholding to your 401(k), you are redirecting that money away from income taxation.

It's important to note that these 401(k) "deposits" do not skirt Social Security and Medicare tax. Each paycheck you earn is subject to a 7.65% tax that covers your contribution toward Social Security and Medicare (https://www.irs.gov/taxtopics/tc751#:~:text=The%20current%20tax%20rate%20for,employee%2C%20or%202.9%25%20). So making a 401(k) contribution will not decrease your Social Security wages. You can sleep easy knowing that if you increase your 401(k) contribution, you will not be lowering your future Social Security payout. 

A 401(k) contribution only side steps your obligation to pay federal income tax (and state tax if applicable). You will have to pay ordinary income tax later in life when you finally end out withdrawing that money. That brings us to the true reason behind the creation of the 401(k). The Revenue Act of 1978 included a provision to allowed employees to avoid being taxed on deferred compensation. And just like that the 401(k) was born. In 1980, The Johnson Companies became the first company to provide a 401(k) to it's workers. Also in 1980 the top marginal tax bracket was 70%. So it made a lot of sense for employees to shield their taxable income by depositing it in a 401(k), letting that money grow tax deferred, and withdrawing the money in retirement. Ultimately paying tax on that money in retirement at a lower rate then they would have while still working, in theory. Since then 401(k)s have grown to become one of the most common type of retirement savings vehicles in America.

401(k) Contribution Limits

There are three main types of contributions that can be made into a 401(k). The first is an employee contribution. This is called an elective deferral. You are electing to withhold a percentage of your pay so it can be placed inside a 401(k) account. An employee can make an elective deferral (contribution) of up to $19,500 in 2021 (unchanged from 2020). Now that is just the limit of what the employee can contribute as their elective deferral. An employer can match an employees contributions above and beyond that $19,500 limit.

Ex: Louis makes an elective deferral of $19,500 into his 401(k) in 2021. He is not allowed to make anymore contributions through elective deferrals this year. However, Louis's employer offers a 5% matching contribution. So the total amount that will go into Louis's 401(k) in 2021 will be his $19,500 and another $975 (5%) from his employer. Totaling $20,475 for the year.

We're not done yet. Above and beyond the employee's elective deferral and the employer match, employees sometimes have the ability to make non-deductible after-tax contributions as well. This is one of those lesser known 401(k) rules. Each individual company and the plan they have created will determine if they will allow employees to make after-tax contributions into their 401(k) accounts. If they do, the total between all three (elective deferrals, employer match, and after-tax contributions) is capped at $58,000. The cap increases to $64,500 for those who are age 50 and over. 

Ex Continued: Let's assume that Louis has the ability to make after-tax contributions to his 401(k). Let's also assume he has excess cash in his bank savings account. He now has the ability to take money from his savings account and deposit that into his 401(k). He will only be able to deposit $37,525 before he hits his cap (Louis is 48 years old). That after-tax money will now grow tax deferred until it comes time to withdraw it. Or Louis may be able to do an in-service conversion of that money into a Roth IRA (see Mega Backdoor Roth Strategy).

401(K) Contribution

Withdrawing From A 401(k)

Saving money over the course of your career and not spending it in retirement isn't ideal. Or at least I hope that isn't the goal for most people. But withdrawing money from a 401(k) can be harder to do than most think. There are rules in place that limit when and how people can distribute money to themselves. These rules were created to help people save for retirement. So with that logic, the IRS has made it extremely difficult for participants to use it like a checking or savings account before retirement begins.

You can withdraw money from your 401(k) whenever you want. It's your money in an account that you own. You can do what you'd like with it. However, there may be tax penalties involved along with ordinary income tax obligations you will be required to pay. In a typical scenario, withdrawing money from your 401(k) before the age of 55 would result in a 10% tax penalty. You would also owe income tax that year on that entire withdraw.

Ex: Louis retires at age 50. He starts withdrawing money from his 401(k). During his first year in retirement he withdraws $60,000. We will also assume that Louis's effective federal tax rate is 14%. He would owe $8,400 in taxes and would incur a 10% penalty of $6,000. He would end out netting $45,600 with his $60,000 withdraw.

When Louis reaches age 55 he will no longer incur that penalty, but will still always have to pay ordinary income tax on his withdraws. I think it's also important to note the age 55 rule. Most people think that you have to get to age 59 1/2 in order to avoid paying the 10% early withdraw penalty. That is true for IRAs. However, with 401(k)s that were active with your last employer (older 401Ks that have been dormant for a while don't count) can be distributed penalty free at age 55. This is a strong case for why consolidating 401(k) accounts from multiple former employers into your active 401(k) is an option that should be considered.

Taking money out of a 401(k) via withdraw isn't your only option. You may also have the ability to take a loan. It's not the worst option in the world if you run into a tough spot and cash flow is tight. Taking a loan from your 401(k) doesn't actually take the money out of your account. It's essentially borrowed from the plan and you pay it back with interest. When you get your 401(k) statement, you will see your full account balance with another entry that shows what you owe on the loan. Taking a loan from your 401(k) is not a taxable event. You also will not be penalized a 10% early withdraw penalty either. This makes it a much more desirable option than a normal 401(k) withdraw itself.

A very important reason to not forget about a 401(k) loan is that if you leave your current employer, you will end up having to pay tax on whatever loan balance is left outstanding, in addition to that potential 10% penalty. And when I say leaving your employer, I mean you quitting, retiring, or getting fired. So be aware that when you take a 401(k) loan you are going to want to pay it back as quickly as you can. You don't want a loan balance and a future tax liability to be the reason for you not taking a new job in the future if an opportunity like that presents itself. 

Before you continue reading, grab this free flowchart that will help guide you through the decision making process of deciding whether you should roll over your dormant 401(k).


What do you do with your 401(k) when you leave your job?

It's rare for people now a days to start a job, work for 45 years at one place and retire. More likely than not, you will find yourself switching jobs at least a couple of times throughout your career. This fact is another reason why 401(k)'s can be so powerful. They are portable. You are not required to keep your 401(k) in your old employers plan if you don't want too. So what are your options?

1.) You can roll your 401(k) into an IRA. You can listen to this PharmD Money Podcast to learn more about this strategy. rolling-a-401k-into-an-ira-is-it-right-for-you

2.) Roll it over into your new or most current 401(k). Usually 401(k) plans allow their participants to move old 401(k)s into their current 401(k) account. The benefit of this would be the ease associated with combing accounts to make it easier to keep track of everything. Your current 401(k) may have better investment options and lower fees, which could really enhance the benefit of this decision.

3.) Keep it where it's at. If you feel comfortable with where your money is currently and feel ok with how the plan is being run, you can always just leave it where it's at. Just don't forget about it. You should continuously be managing your dormant 401(k)'s on an ongoing basis.

Some older individuals who are approaching retirement usually find themselves rolling their accounts into an IRA. The main reason for this is to allow a financial advisor to help with the management of that money. Younger investors or Do It Yourselfers will most likely roll an old 401(k) into their new plan. It's easier to manage one account than it is two. Historically, it's been more cost effective to keep money in a 401(k) compared to an IRA.

What is a 401(k)

Roth 401(k)s

Everything we've talked about to this point is in line with what a Traditional 401(k) is all about. However, it's becoming more common now for employers to offer Roth 401(k) options inside their 401(k) plan. A Roth 401(k) is very similar to a Traditional 401(k). The big difference is the tax treatment of your contributions and distributions. 

When you contribute money to a Roth 401(k), it's coming from a percentage of your paycheck that has already had money withheld for income and employment tax. It's money that is being deposited after-tax. So on the front end you don't save any money in taxes, because your entire paycheck gets taxed before you make the contribution into the 401(k). This would result in a lower net payout to the employee on each of their paychecks. So why would anyone want to use the Roth option?

The biggest reason is that when it comes time to pull money out of a Roth 401(k), all of that money comes out tax free. Going back to our Louis example, lets assume he has all of his money in a Roth 401(k) and makes a $60,000 distribution. Lets also assume he is over age 55. When he withdraws $60,000, he will net $60,000. There is no tax liability associated with his withdraw because there was no tax benefit given to him on the front end when he put the money in. This could be a huge tax benefit if you find yourself in a higher tax bracket while in retirement. It's also important to know that any employer match always goes into the Traditional 401(k) side. So even if you are making all of your contributions toward a Roth, you may end up still having some traditional 401(k) money accumulating if you are receiving an employer match.

Bottom Line

401(k)s are not as simple as just opening an account and saving money. We barely scratched the service of all of the moving parts that are happening behind the scenes. We didn't touch on investment options, net unrealized appreciation, ESOP, and all of the other stuff that could impact your 401(k) account. So as your account value grows and as you get closer to retirement, you need to become more diligent with everything that is happening. A 401(k) is a tremendous way to save for retirement. Do your best to maximize it's full potential. 

Derek Delaney is a Minnesota (Minneapolis / Rochester area)  Fee-Only financial advisor serving clients across the country. PharmD Financial Planning provides professionals and families with financial planning and investment management with a focus on tax-efficient retirement planning.

As a fee-only, fiduciary, and independent financial advisor, Derek Delaney is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.

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