The 401(k) gets its name from that section of the Internal Revenue Code that allows employees to contribute a portion of their income to a retirement account on a pre-tax basis. And given the decline of pensions and the rise of defined-contribution plans, the 401(k) has become the dominant retirement savings vehicle for many workers. As the burden of saving for retirement continues to shift from the employer to the employee, it is perhaps more important than ever that individuals learn about their options when it comes to saving for retirement. Here are five important aspects of the 401(k) that you should know.
1. Higher contribution limits
Americans aren't saving nearly enough for their future, but for those who are willing and able to save a big chunk of their income, the 401(k) allows larger annual contributions than other tax-advantaged retirement accounts. For 2017, you can save $18,000 in a 401(k) plan, or $24,000 if you're age 50 or older. Compare that with the contribution limits for the traditional or Roth IRA, which are $5,500 for those under 50 and $6,500 for those 50 or older. Using those current limits, if you saved $5,500 a year for 30 years, earning a conservative 6% return, you'd end up with about $460,000 (not accounting for inflation or rising contribution limits). Meanwhile, if you saved $18,000 a year for 30 years, earning the same 6% return, then you'd have about $1.5 million. That's a big disparity in savings, and it could mean the difference between just getting by and living a worry-free, comfortable retirement.
2. Employer match = free money
You may have heard the expression that there is no such thing as a free lunch, but this perk comes pretty close. If your employer matches your contributions, then that really is free money, which you should not miss out on. So even if you have limited resources, you should at least contribute up to the matching point.
3. Access to a Roth 401(k)
Generally, contributions made to a traditional IRA or 401(k) are made on a pre-tax (or tax-deductible) basis and continue to grow on a tax-deferred basis until the money is withdrawn, at which point it's taxed as ordinary income. Conversely, contributions made to a Roth IRA or 401(k) are made with after-tax dollars, but the money then has the opportunity to grow tax-deferred and be withdrawn tax-free -- assuming all other guidelines are followed.
In 2017, those of you who are single and make $133,000 or more, and those who are married and make $196,000 or more, cannot contribute to a Roth IRA (not considering the "backdoor" method). But if your employer offers a Roth 401(k), then you can contribute, as there are no income restrictions on that form of Roth account. Having access to both types of accounts is beneficial, as it provides individuals with the opportunity to diversify their assets among accounts with different tax treatments.
4. Unlimited creditor protection
As a qualified plan under the Employee Retirement Income Security Act of 1974, or ERISA, the 401(k) allows for unlimited protection of assets from creditors, specifically if you file for bankruptcy (although this protection does not apply to divorce proceedings or claims from the IRS). And while IRAs have some protection under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, ERISA-backed accounts have the upper hand in providing rock-solid protection of your 401(k) retirement assets.
5. A possible exception to the RMD rule
While the government allows you to shelter your retirement assets from taxes for much of your life, they aren't protected forever. Thus, in general, when you reach 70-1/2, you will need to begin withdrawing money from your retirement accounts (one notable exception to this rule is the Roth IRA). However, if you're still working at 70-1/2 when required minimum distributions (RMDs) are set to begin for the majority of retirement accounts, you may be able to delay having to withdraw money from your active 401(k) until you retire, if your plan allows for it. You will still need to begin taking RMDs from all your other eligible accounts.
If you aren't yet contributing to your company's 401(k), now is the time to consider your options and to get started today.