401(k) Plans

401(k) Plans — The power of tax-deferred payroll contributions


401(k) Plans — The power of tax-deferred payroll contributions

Named after the section of the tax code that helped create them, 401(k) plans are among the most common employer-sponsored retirement savings plans available to American workers. A 401(k) is considered a defined contribution plan because participants decide (or define) how much they want to save (contribute) in their 401(k) plan accounts.

These flexible plans offer a number of benefits:

401(k) plans offer a combination of benefits to help you save for retirement.

  • Current tax deductions — Contributions are deducted from your paycheck up to certain IRS-defined annual limits. Contributions can be designated as a specific dollar amount or percentage of your pay. The contributions are taken before taxes, lowering your current income tax bill. You will owe income taxes when you make a withdrawal from the plan. Withdrawals prior to age 59 ½ are also subject to a 10% IRS early withdrawal penalty, unless an IRS exception applies.
  • Tax-free retirement income — Some plans allow you to make contributions to a Roth 401(k) account. Roth contributions are made after you’ve paid taxes on the income, but qualified withdrawals may be taken tax-free in retirement.1
  • Tax-deferred investment earnings — Investment earnings grow tax deferred, which means you don’t pay taxes on the earnings until you withdraw the money. Since your earnings are reinvested, the account may grow faster than a comparable taxable account.
  • Employer matching contributions — Many employers help their employees save by matching a portion of their contributions up to a certain percentage of pay. If your employer offers a match, consider contributing enough to get the full match amount. Otherwise, you are leaving money on the table.
  • Focused investment options — Participants can choose from a focused menu of investment funds that have been screened as being appropriate for diversified retirement investing. Some plans offer “one choice” asset allocation funds that can help simplify the decision-making process.
  • Ability to borrow your own money — Some plans offer a loan feature that lets you borrow against your savings balance well before retirement. The loan and interest is paid back, through payroll deductions. Loans should be used with caution. If you leave your employer, you may have to repay the loan immediately. If it cannot be repaid, the loan is then considered an early withdrawal and a 10 percent early withdrawal penalty and current income taxes will likely be applied.
  • Personal control — You decide how much to save and where to invest your savings. You control your contribution amount and your investment choices. If you leave your job, you can transfer your vested account balance into another employer’s plan or roll it over into an IRA. Many plans also give the flexibility of taking money from the plan at age 59½, even if you are still employed.

Hooray for the 401(k)

For many employees, a 401(k) plan may offer a combination of retirement savings benefits such as tax-deferral and matching contributions. The hands-on features put you in control of your retirement savings strategy.

1 A qualified distribution of designated Roth contributions is excludable from gross income. A qualified distribution is one that occurs at least 5 years after the year of the participant’s first designated Roth contribution (counting such first year as part of the 5) and is made:
- On or after the participant’s attainment of age 59½,
- On account of the participant’s disability, or
- On or after the participant’s death.

If the distribution is not a qualified distribution, then the accumulated Roth 401(k) earnings will be subject to tax, and additional taxes may apply. Roth 401(k) amounts are subject to the same required minimum distribution rules as other contributions made to the 401(k) plan.