Due to high administrative costs, traditional pensions are waning in popularity with employers. 401(k) and other employer plans are quickly taking their place.
Why a 401(k) is such an advantage
A 401(k) is a savings plan provided by your employer. Take a look at three big benefits provided by your 401(k).
- A 401(k) allows your invested money to grow tax deferred. What this means it the money you earn will not be taxed now, but only when you take out distributions in retirement. It provides all important compounding of interest over time. If you invest in an account that is not tax deferred, the earnings are taxable to you each year, but not with your 401(k).
- Another powerful impact, when you contribute to your 401(k), the contribution occurs on a pre-tax basis. Hypothetical example: If you earn $1000 and you contribute $100 pre-tax to your 401(k), you will only pay tax on $900 of earnings ($1000-$100=$900).
- Since you are not paying tax on your full $1000 of earnings (from example above), this may put you in a lower tax bracket.
Wow, three savvy ways for your money to be working hard for you.
Benefit to employer (ER)
Employers (ER) benefit too. Though the ER pays fees to both set up and administer a 401(k) plan, the advantages may out weigh the cost and often quite significantly. “The government wants to encourage retirement savings—and as a result, the IRS grants some valuable tax benefits that can really add up over time.” (How an Employer Benefits from Offering a 401(k) 2020) Tax credits may be realized by an employer setting up a 401(k) for their company, this is intended to offset the initial set up costs. Employer matching contributions to the employees account are tax-deductible to the ER. Additionally, if the ER has the plan set up with a vesting schedule, it behooves the employee to stay with the company at least until they are fully vested. This reduces employee turn over which can be a big benefit for employers. Now you may be thinking, “hold on, does this mean I may lose the money I contribute if I don’t stay with my employer for a certain amount of time?” No, don’t worry, the money you contribute is yours. A vesting schedule applies to the employer match. Federal law applies to vesting schedules. When setting up a plan, an employer may choose immediate, graded, or cliff vesting. Immediate vesting is just that, the amount your ER contributes to your 401(k) is immediately 100% vested. It’s yours (there are requirements which must be satisfied for you to take a distribution from the account, but we will cover that in just a bit). If your ER chooses a graded vesting schedule, the vesting schedule works like this, ER contributions are 0% vested at the end of year 1, 20% after year 2, 40% year 3, 60% year 4, 80% year 5, and after the 6th year of your employment you will be 100% vested. Cliff vesting is a pre-determined amount of years with the max being 3 years. Hypothetical example, if you leave your employment after only 2 years you walk away with 100% of the deferrals you made, but the employer contributions have not yet vested. If you wait until the end of year 3 before you leave your employer, you keep everything you deferred plus 100% of your employers contribution.
Additional benefits to employee (EE)
People say it’s like free money. You don’t have to do additional work to receive an employer contribution. All you have to do is participate in the plan by contributing, then your ER makes a match up to a certain percent. In 2020, you can defer up to $19,500 to your 401(k). If you are age 50 or older, you can increase this deferral by an additional $6500 considered as a catch-up. Between your EE deferral and your ER’s contribution and match, your 401(k) annual limit in 2020 allows for a total of $57,000. Therefore, if you defer $19,500 in 2020, your employer could contribute $37,500. More than likely they will not be contributing that much, but they could.
Accessing your 401(k)
Access restrictions apply to your 401(k). Being fully vested in your 401(k), “does not mean you are scot-free to touch the money.” (Dixon, 2020). Remember, the government intends this account to provide a source of financial security in your retirement retirement years. To encourage that you do not take distributions from your account too soon, a 10% early withdrawal penalty applies to distributions taken prior to age 591/2. Additionally, if you are under age 55 you only have two options if you need your money right now. You can take a loan from your 401(k) or if you meet eligibility requirements you may be able to take a hardship distribution. If you are between age 55 and 591/2, many 401(k) plans allow penalty free withdrawals. “To use this 401(k) retirement age 55 provision your employment must have ended no earlier than the year in which you turn age 55, and you must leave your funds in the 401(k) plan to access them penalty-free.” (Anspach, 2020) Once you have reached age 591/2 you have met all age restrictions, but if you are still working your plan may or may not have an in-service provision for distributions.
What to do with your 401(k) when you retire
When you retire, you can leave your funds in your 401(k) and take penalty free distributions. You will be required to pay tax on your distributions. You can also roll your 401(k) to an IRA which may provide you with a broader spectrum of investment options.
Again, the government encourages the use of retirement plans like a 401(k) by allowing your money to grow tax deferred until distribution. Over time this can have a huge impact on the growth of your account due to compounding interest and this is great. However, you will have to pay tax when you take your money out and 10% penalty if you take early distributions. At age 72, Uncle Sam finally requires you to begin taking your money out a little at a time so you have to pay tax, this is the age of Required Minimum Distribution (RMD). From age 72 until you pass, you will be required to take a little less than 4% of your accounts year end value annually.
Tax deferred growth, pre-tax contributions, and potential to lower your tax bracket. Wow, three savvy ways for your money to be working hard for you. Your employer may receive both tax credits and their contributions are tax deductible. Often there are vesting periods and you will want to speak with your HR department to learn more about the particulars of your employers plan. This conversation with HR should include additional inquiries about age restrictions for accessing your funds. Once you retire, you have options for what you can do with your 401(k). Talk to both your tax professional and financial planner for guidance.
About the Author
My name is Marianne Martini Nolte, CFP® As a Certified Financial Planner™ practitioner, I provide fiduciary financial advice and services for individuals, families, and small business owners. In particular, I have a passion for working with women in transition, new investors just starting on their path to financial independence, and those seeking special needs planning. This article is intended as a high level view. For more in depth information, please reach out:
Marianne Martini Nolte, CFP®
Imagine Financial Services
Phone, (760) 846-2569.
Anspach, D. (2020, April 30). Information You Need About When You Cab Tap Your 401(k) Money. Retrieved July 12, 2020, from https://www.thebalance.com/what-age-can-funds-be-withdrawn-from-401k-2388807
Dixon, A. (2020, February 05). What It Means to Be Fully Vested in a Retirement Plan. Retrieved July 12, 2020, from https://smartasset.com/retirement/being-fully-vested-in-a-retirement-plan
How an Employer Benefits from Offering a 401(k). (2020, June 30). Retrieved July 12, 2020, from https://www.betterment.com/resources/the-top-three-401k-benefits-for-employers/
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