What Is a 401(k) Plan?
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- A 401(k) plan is a defined-contribution retirement savings account that may be financed using net or gross income.
- The annual expected rate of return on a 401(k) is generally 8%-10%.
- The maximum annual contribution amount of a 401(k) in 2020 was $19,500.
What Is a 401(k) Plan?
A 401(k) plan is a company-sponsored retirement savings account, in which employers and employees make monetary contributions to a retirement account for the employee. 401(k) plans have defined contribution parameters and are managed by a third party, typically an employer, and not the account holder.
401(k) accounts are not “owned” per se, because multiple parties contribute to the fund. But some employers permit employees to choose from mutual funds, investment contracts, or other debt instruments as an investment vehicle for the 401(k).
Employer Contributions to a 401(k)
As part of a 401(k) plan, employers can match some or all of the employee’s contributions to the account. Most employers commit to matching a minimum percentage of the employee’s contributions.
The total contribution by employer and employee may not exceed $57,000 each year, or $63,500 per employee over the age of 50. Individual contributions to a 401(k) are capped at $19,500 for employees 49 and younger, and $27,000 for individuals who are 50 years or older.
The addition of the employer’s contributions means the employee can amass considerably more retirement savings than otherwise would have been possible through an Individual Retirement Account (IRA). However, employers adjust contribution amounts based on the inflation rate, thus high inflation may lead an employer to reduce its contributions to an employee’s 401(k).
Required Minimum Distributions
The employee who has invested in a 401(k) is subject to required minimum distributions (RMDs) when that individual retires or is older than 72 years. In other words, the 401(k) owner is penalized for failing to access the funds after the age of 72 and penalized for accessing the funds before the age of 59.5.
How Is a 401(k) Taxed?
A 401(k), like other retirement plans, may be financed with net or gross income. Roth 401(k)s are funded with net income, whereas Traditional 401(k)s are funded with gross income. Net income has already been taxed, which means that future distributions from a Roth IRA are tax free.
Alternatively, gross income has not been taxed, which means that distributions from a Traditional IRA will be taxed at the income tax rate of the 401(k) beneficiary at the time of withdrawal. Technically, there are no capital gains on 401(k)s because all distributions and earnings are taxed as income.
Roth 401(k) Taxes
Under a Roth 401(k), employees invest net income and withdrawals are tax free, so long as the account has been open for five years and the employee is older than 59.5 years. In other words, contributions to a Roth 401(k) are not tax deductible, but withdrawals from a Roth 401(k) are tax deductible.
Traditional 401(k) Taxes
Under a traditional 401(k), employees invest gross income, so employees may reduce taxable income in the present time, but will pay taxes on withdrawals. In other words, Traditional 401(k) plans include tax deductible contributions, but withdrawals from the account are taxed.
401(k) vs. Pension
A 401(k) plan is different from a pension because pensions are based on defined benefits, not defined contributions. Under a pension plan, the employer guarantees a specific benefit to the employee and will bear the risk of failing to meet that obligation.
A 401(k), on the other hand, only guarantees that the employer will contribute to the same retirement fund as the employee. 401(k)s are not insured and therefore are subject to more market risk than pension plans, which the Pension Benefit Guaranty Corporation insures. As a result, employers are slowly replacing pensions with 401(k)s because they shift more of the burden of retirement savings onto the employee.
401(k) vs. IRA
The primary difference between a 401(k) and an Individual Retirement Account (IRA) is the number of parties involved. A 401(k) is provided and managed by an employer who receives tax deductions for contributing to employees 401(k). In contrast, an IRA is an individual retirement account managed by the person who opened it abd 401(k)s have a higher maximum contribution amount than IRAs. Some employers do not allow employees to select the assets they invest in through a 401(k). Alternatively, the owner of an IRA has more control over their asset allocation. However, an IRA can only be funded with $6,000 each year, whereas the maximum contribution for a 401(k) is $19,500.
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