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Just about everyone has at least heard of a 401(k), even if they aren’t exactly sure what they are or how they work. With that in mind, here are some basics about 401(k) accounts.
What is a 401k plan?
The name of the plan – 401(k) - comes from the tax code that the IRS uses to designate this type of retirement account. That’s because 401(k) accounts are directly tied in to how you pay income tax on the money deposited and earned over time.
The typical retirement plan prior to 401(k)s is what is commonly known as a pension. While pensions still exist, they are becoming increasingly rare. Starting in 1978, 401(k)s have allowed employees more control over how their retirement money is invested, and provide employers with a less expensive way to offer retirement benefits to staff. The former is often referred to as a defined contribution plan, and the latter as a defined benefit plan.
There are tax advantages to investing in a 401(k) as well, in particular that this type of account allows you to make contributions to your retirement fund on a pre-tax basis.
For the sake of easy math, that means that if you earn $100,000 a year, and defer 5% of that to your 401(k), you’re investing $5,000 over the course of the year. Because you are essentially deferring that 5% of income to the retirement fund and not your pocket, you will only be taxed on $95,000 worth of income for the year.
Depending on your tax bracket, this type of deferment could provide considerable savings at tax time.
What are the types of 401k plans?
Most employers only offer what’s known as a traditional 401(k), though some do offer a Roth version. The difference between the two is whether or not you want the money to be taxed now or later.
- Traditional 401(k): The money you put into the account will be taxed later, when you withdraw the funds from the account, most likely at the time of retirement. You can also rollover the funds into an IRA.
- Roth 401(k): This money is taxed now, or, in other words, during the tax year in which it is deposited. You won’t be taxed again on the money when you withdraw it at your time of retirement.
Which option is right for you? The answer depends on your predicted tax bracket at the time of your anticipated retirement. That’s where talking with your financial advisor and accountant comes in handy.
What’s the difference between a 401k and a pension?
- 401k: Funded by the employee. You have control in how the money is invested. If you’re lucky, your employer will kick in a few percentage points of your salary as a match. If you’re really lucky, your employer might offer an additional percentage of your salary to go in your retirement plan even without a match.
- Pension: Funded by the employer. Employees have no say in how the money is invested. In return, the company commits to paying the employee a set amount of money each year for life, after that employee has completed a set number of years of service. As you might imagine, you will have to work at that company for a significant amount of time to qualify to receive some or all of the pension.
What if you change jobs?
The 401(k) is designed to be a long-term retirement solution. While the money is yours, there are steep financial penalties for making withdrawals before retirement age. Since the money is invested through your employer, what if you change jobs?
You’ll have three options:
- Rollover. “Rollover” is a financial term that means you are transferring the money from one qualified account to another without cashing it out. In other words, you are just moving it from one 401(k) to another.
- Withdrawal. The money is yours to cash out if you want, but you’ll have to pay a 10% penalty plus taxes on the money.
- Do nothing. You can also leave the money right where it is. You will no longer make contributions to that account once you change jobs, but the money can stay invested right where it is, for as long as the company stays in business. Be sure to keep track of the number of 401(k)s you have with different companies if you change jobs several times.
If you’re new to investing or want to learn more about your retirement accounts and how they work, a conversation with your financial advisor is the best next step. They can help you decide if a traditional or Roth 401(k) is right for you, and what to do with the money should you change jobs. Above all, the most important thing with all things financial is to continuously learn more about your money and how it can best work for you.