401(k) plans allow employees to accumulate retirement savings on a tax-advantaged basis, and employers may offer them for several reasons, including as an incentive to attract and retain talent. If your employer offers such a plan and you’re thinking about participating, here are a few things to know.
A 401(k) plan gives you the option to set aside a portion of your wages and place them in a qualified retirement plan. When cash is set aside in a 401(k) plan, your gross income is reduced and the tax on the amount set aside is deferred until it’s distributed to you (adjusted by earnings). These earnings will either be distributed from the plan or (if you choose to roll the proceeds into another plan after leaving your job) from an IRA or whatever other plan you roll them into.
401(k) plan advantages
A 401(k) plan saves you current income taxes by reducing wages and other compensation by the amount of your pre-tax contributions. However, these earnings are still subject to Social Security and Medicare taxes.
Your employer’s plan may also allow you to make some or all of your contributions as Roth 401(k) contributions (contributions made on an after-tax basis). Amounts set aside in Roth 401(k) contributions are subject to current income taxation. However, distributions (including earnings) will be tax-free if the funds are left in the plan for a required time.
Annual IRS limits apply to all elective contributions, whether pre-tax or after-tax. The maximum permitted amount of contributions for 2021 is $19,500.
Once you reach age 50, your employer's plan may allow you to make additional “catch-up” contributions (this additional amount is limited to $6,500 for 2021). Because of this, employees age 50 or older may contribute a total of $26,000 in 2021 to all 401(k) plans. Total employer contributions, including elective deferrals, are also limited to the lesser of 100% of compensation or, for 2021, $58,000 (catch-up contributions are exempt from this limitation).
In most cases, the amount of your contributions, as well as employer matching and other contributions, can be invested among certain investment options selected by your employer. You’ll want to review your plan investment performance periodically to make sure that each investment is still suitable for your risk specifications and retirement planning goals.
Limits on distributions
When considering a 401(k) plan, it’s important to know that there’s a limitation on distributions as long as you’re still working. Amounts in the plan that are set aside through elective contributions won’t be available to you until you reach one of the following events:
- Retirement (or other separation from service)
- Plan termination
- Reaching age 59½
- Disability
- Hardship
Hardship withdrawals are also governed by stringent eligibility requirements and must be deemed necessary in order to satisfy an immediate and significant financial need.
Some employer’s 401(k) plans may allow you to receive a plan loan as an alternative to taking a hardship withdrawal or other plan withdrawal. These loans are paid back to your account, with interest. You may roll any distribution that you do take into an IRA or another employer’s plan (so long as that plan permits it), which allows you to continue deferring tax on the amount rolled over. Generally, if taxable distributions are not rolled over, they’re subject to 20% federal tax withholding.
Your employer may opt to make matching contributions up to a certain amount—if so, it’s a good idea to contribute enough to receive the full match. You’ll miss out on free money otherwise!
This is only a basic overview of 401(k) plans for employees. If you need more information about a specific plan, contact your employer. We can also answer any tax questions you may have.