A 401(k) is a tax-advantaged retirement account, usually offered through an employer. Employees may elect to defer a certain percentage of their paychecks to their 401(k), and employers often match some of these contributions.
The different types of 401(k)s differ in eligibility requirements and how they are taxed. Here's everything you need to know if you're thinking about contributing to a 401(k).
Benefits of a 401(k)
- Tax savings: Traditional 401(k)s are tax-deferred, which means your contributions reduce your taxable income for the year, but you will owe taxes on your withdrawals in retirement. If you believe you're in a higher tax bracket today than you will be in retirement, delaying taxes can save you money.
- High contribution limits: 401(k) contribution limits are much higher than limits for IRAs.
- Employer match: Employers often match a percentage of their employees' contributions. This is like getting a bonus and reduces how much you must save for retirement on your own.
- Automatic contributions: You can elect to defer a percentage of each paycheck to your 401(k), so you don't have to make retirement contributions manually. You can also change your contribution percentage at any time.
- Rollovers after leaving the company: If you leave your employer, you may keep your retirement savings in your old 401(k) or roll them over into your new company's 401(k) or an IRA.
401(k)s are company-sponsored retirement plans, so as soon as you meet your company's eligibility requirements, you may enroll and decide how much you would like to contribute each pay period. Some companies automatically enroll employees in their 401(k) plans. Check with your company's HR department to learn more about your plan.
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You may contribute only up to $19,500 to a 401(k) in 2020, unless you are 50 or older, in which case you may contribute an extra $6,500 in catch-up contributions. These limits can change yearly.
People classified as highly compensated employees (HCEs) by the IRS -- those who own more than 5% of the company they work for or earn more than $130,000 in 2020 -- may not be able to contribute up to the specified limits even if they want to. Those in the top 20% of their company by income may also be classified as HCEs if their company chooses.
Employers must perform nondiscrimination tests annually to make sure HCEs aren’t contributing significantly more than non-HCEs. Long story short, average HCE contributions cannot be more than 2% higher than annual non-HCE contributions. If they are, HCEs will not be able to contribute up to the annual limits outlined above.
You may designate any person you like to inherit your 401(k) when you die if there are funds remaining in the account. If you fail to designate a beneficiary, the money usually goes to your spouse or your estate.
Review your beneficiaries at least annually. If you get divorced, you may not want your ex-spouse as a beneficiary anymore, and if you have children or your existing beneficiaries die, you will want to choose new ones.
Withdrawals from a 401(k)
You may take money out of your 401(k) at any time, but you will pay a 10% early withdrawal penalty if you do so before 59 ½, unless you have a qualifying exception. Qualifying exceptions include large medical expenses, educational expenses, and first-home purchases, among others.
Required minimum distributions
Required minimum distributions (RMDs) are mandatory distributions everyone must take from 401(k)s beginning at 72. Before 2020, RMDs began at 70 1/2. If you reached this age before 2020, you must start RMDs at 70 1/2. Calculate yours by dividing your 401(k) balance by the distribution period next to your age in this table. Failure to withdraw at least this much results in a 50% penalty on the amount you should have withdrawn.
Adults 72 and older who are still working may delay RMDs from their current 401(k) until they retire, though if they have any old 401(k)s from former employers or IRAs, they must still take their RMDs from these accounts at 72.
Rule of 55
The Rule of 55 permits those who quit their jobs or are fired in the year they turn 55 or later to take penalty-free withdrawals from their 401(k) even if under 59 1/2. Public safety workers are eligible for penalty-free distributions if they leave their jobs once they turn 50. You may take penalty-free distributions only from your most recent 401(k), not from other retirement accounts.
Some 401(k)s enable participants to borrow money from their plans and pay it back over time with interest. This can be a nice alternative to a traditional bank loan for some, but it could slow the growth of your retirement savings. If you are unable to pay back everything you borrowed by the end of the loan term, the outstanding balance is considered a distribution and taxed accordingly.
Types of 401(k)s
401(k)s come in several varieties. Most of the above information centers on tax-deferred 401(k)s, which are the most common. But other types of 401(k)s include:
|Roth 401(k)||This is the same as a tax-deferred 401(k), except that contributions are made with after-tax dollars. They don't reduce your taxable income for the year, but then you don't owe taxes on distributions in retirement. Employer-matched funds, however, are still considered tax-deferred with these plans.|
|Solo 401(k)||A solo 401(k) is available only to self-employed people. It allows greater contributions every year because you can contribute as both employee and employer.|
|Inherited 401(k)||An inherited 401(k) is what a beneficiary inherits when the original 401(k) owner dies. The beneficiary may not contribute more money to this account and must withdraw it within a set number of years. They may also roll it into their own 401(k), if the original owner was their spouse.|
|Highly compensated employee 401(k)||This is not a special type of 401(k). HCEs may contribute to the same 401(k)s as non-HCEs, though, as explained above, how much they can contribute may vary.|
401(k)s versus other retirement accounts
Contributing to other accounts
You may contribute to multiple retirement accounts in the same year, but note that contribution limits apply to all accounts of the same type. You may not contribute $19,500 to a tax-deferred 401(k) in 2020 and $19,500 to a Roth 401(k), for example. You may contribute some money to each type of 401(k), but the total may not exceed $19,500, or $26,000 if you're 50 or older. Contributions to other types of defined contribution plans, like 403(b)s, also count against your 401(k) contribution limit for the year.