401k Retirement Plan BasicsJan 13, 2020
By Glenn J. Downing, MBA, CFP®
It used to be the case that you went to work for one employer and remained with that employer for the entirety of your working life. You received a pension from that employer when you retired – in other words, you continued to get paid a lesser amount even though you’d stopped working.
This arrangement is no longer the norm – people expect to change jobs several times during their working lives. A 401K retirement plan suits this kind of work environment. When you leave one employer, you can move your 401K funds into the 401K of your new employer, or over to a Traditional IRA. In any event, the responsibility for providing a retirement income lies firmly with the worker!
How much can I contribute?
Contributions are limited by IRS regulation. The maximum deferral that a plan participant can make in 2020 is 100% of salary up to $19,500. If you are age 50 or older, you may be able to make an additional $6,500 “catch-up” contribution as long as you first contribute the annual maximum.
What investments are available to me?
You typically have a small universe of mutual funds to which you can allocate your contributions. These will usually cover the risk spectrum, from conservative government bond funds, to more aggressive growth funds. More speculative choices tend to be absent, as they are not generally recommended in a retirement account. If the 401K retirement plan is sponsored by a particular mutual fund company, you’ll find that company’s funds as the ones available. If the 401K is sponsored by an insurance company, you’ll generally also have a variable annuity choice, with mutual-fund-like sub-accounts from which to choose. We generally do not recommend the variable annuity within a qualified plan. The annuity has its own set of costs, which have the effect of slowing down the returns in the account.
Your portfolio should match your risk tolerance and time horizon. As a rule, the closer you are to your retirement, the more conservative you should be. Why is that? If there were a big market correction, you may not have enough working time left to continue contributing and recoup your losses.
What are the tax benefits?
Salary dollars that you defer into your 401K retirement plan are contributed pre-tax. This means that the money going into your account is not listed as federally taxable income on the W-2 form that your employer provides. These ARE subject to payroll taxes, though, and the usual 6.2% social security tax and 1.45% Medicare tax are withheld.
The other huge benefit is that these contributions, and all growth occurring within the account, are all tax-deferred until you withdraw the funds. At that point withdrawals are added to your other income in the year withdrawn to be taxed then. Consequently, you could potentially enjoy years and years of tax-free accumulation and growth.
Will my employer make contributions to my account on my behalf?
Maybe yes; maybe no. Employer contributions can be of two natures: profit sharing, and/or matching. If profit-sharing, the only IRS rule is that contributions be substantial and recurring. This means the amount and frequency of profit-sharing contributions can vary year by year. The matching formula must apply to every employee contribution. A typical matching formula is this: the employer matches you dollar-for-dollar up to 3% of your pay, and then fifty cents on the dollar up to 5% of your pay. To make the math easy, say you earn $100,000. You defer 5% of your salary. The employer would kick in $3000 on the first match, and $1000 on the second match.
Is there a vesting schedule?
For employer contributions, yes there is. For your own deferrals, no. Consequently vesting comes into play only should you leave your employer, and you’re wondering how much of your account you can take with you. The money you put into your account is always 100% vested and always entirely yours. Money your employer puts in is likely subject to a vesting schedule. A typical one is over 6 years: After year one you are 0% vested. After year two you are 20% vested, and so on.
Still have more questions?
Check out Jonathan's piece on 401k & Young Investors. Feel free to get in touch with us at [email protected] Also follow us LinkedIn, Facebook, Instagram, and YouTube for more personal financial information relevant to you!
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