Not long ago employees relied on Social Security and employer pension plans to support them through retirement. Over the last three decades, the number of employer-sponsored pension plans has declined significantly. Because of rising costs and adverse business conditions, many employers have opted to eliminate the pension plan in favor of a 401(k) plan resulting in cost savings for the business.
401(k) plans, named after the section of the tax code that governs them, is an employer-sponsored retirement savings plan where employees can defer a portion of their income and save for retirement. In addition, the employer has the option to make contributions on behalf of the employee as well. Employers can make contributions without regard to employee contributions or by using a matching structure that gives employees an incentive to contribute to the plan. Employer contributions are made on a pretax basis meaning they will accumulate free of tax until the employee begins to withdraw money in retirement at which time contributions and earnings are taxed. Employer contributions and matching are useful to attract and retain talent for an employer.
Traditional 401(k) versus Roth 401(k)
Depending on how the plan is set up, employees may be able to contribute dollars to a traditional 401(k) on a pretax basis or to a Roth 401(k) on an after-tax basis. If the employee elects to contribute pretax dollars, this means the employee does not pay taxes on the amount he or she contributes to the 401(k) plan. Instead the employee pays tax when the money is withdrawn from the account. For example, if an employee makes $60,000 per year and puts $5,000 of the total into a traditional 401(k) plan then the employee pays taxes only on the remaining $55,000, a significant tax savings in the current year. However once the employee retires, he/she will pay tax on all withdrawals from the account.
On the other hand, if the employee chooses to contribute to a Roth 401(k), the employee would be taxed on the full $60,000 per year even though $5,000 was put into the retirement account. Once the employee retires all money withdrawn from the account is tax-free. Remember, while the employee has the option to contribute on a pretax basis or after-tax basis, all employer contributions are pretax.
Deciding which one is right for you depends on factors such as your current tax situation and your expected tax bracket in retirement. Regardless, the maximum amount an employee can contribute to a traditional or Roth 401(k) plan is $18,000 per year. If you are age 50 or older, you can make an additional contribution of $6,000 per year for a maximum of $24,000.
401(k) Loans and Distributions
If the plan allows loans, the maximum amount an employee can borrow from the 401(k) plan generally is the lesser of 50% of the vested account balance or $50,000. Every plan is different and some companies only allow employees to take out loans for specific reasons. An employee must pay back the loan in five years with some exceptions. There is usually interest on the loan but no penalties for taxes.
There is a special 55 rule for qualified plans that provides for early withdrawal without the 10% penalty if you are 55 or older and separate from service with your employer. Participants can start drawing down a 401(k) plan, penalty free, once the employee reaches age 59 ½ . Once the participant reaches 70 ½, he must begin to take withdrawals. If the employee is still working at age 70 ½, generally they are permitted to delay withdrawing the Required Minimum Distribution (RMD) from the 401(k) until retirement. However, individuals who do not take their RMD by the prescribed deadline will owe the IRS a 50% penalty on the amount not distributed.
How much should you contribute to your 401(k)?
At a minimum you will want to make sure you contribute enough so that you receive the full amount of your employer match. Besides that, the amount to save depends on how much money you think you’ll need in retirement. Looking at life expectancy, a couple reaching the age of 65 has a high likelihood of at least one spouse living into his/her 90s. With the increase in life expectancy, coupled with concerns about the future of Social Security and the decline in the availability of traditional pensions, many workers worry that they won’t have enough money set aside for retirement. The best thing you can do is start saving as much as possible as soon as possible. In addition, if you use a tax efficient vehicle such as a traditional 401(k) plan, your portfolio will grow more quickly as earnings are not taxed until withdrawn.
New Fiduciary Rules Effective April 2017
The Department of Labor’s new fiduciary rules, outlining standards for the financial industry regarding fiduciary responsibility, will go into effect in April 2017. The new rules require advisors to put the best interest of their clients above their own financial interests.
What is fiduciary responsibility and how will it benefit you?
- Ensures your 401(k) plan providers choose investments with no consideration to commissions or fees they might receive
- Requires providers to act in the best interest of their clients
- Reduces the potential for backdoor payments or hidden fees buried in fine print
Check if your 401(k) plan provider is a Registered Investment Advisor (RIA) and regulated by the Securities and Exchange Commission.
All information herein has been prepared solely for informational purposes only and opinions are subject to change. Past performance is not indicative of future results and all investments involve the risk of loss of principle. For information on how these general principles apply to your situation, consult an investment professional.