What is a 401k?

A 401k is a tax-advantaged retirement account sponsored by an employer. The tax implications differ based on whether the 401k plan is a “traditional” plan or a “Roth 401k”. When not otherwise stated, most people refer to traditional 401ks as simply a “401k”, as Roth 401ks are newer and less common.

A traditional 401k allows an employee to save for their retirement using pre-tax money – thereby reducing their taxable income in addition to putting money aside for retirement. The money is taxed when withdrawals are made from the account. Using this type of plan, you are deferring your taxes until retirement.

A Roth 401k (like it’s Roth IRA counterpart) uses a different tax-advantaged approach. Contributions are made with after-tax money, and withdrawals are not taxed. Using a Roth 401k plan you are paying taxes up front for the benefit of avoiding them later.

See the section on “Tax Advantages” below for more details on why someone would choose one over the other.

Limits

401k contributions are limited per calendar year. The current 2013 contribution limit is $17,500. Contribution limits are indexed to inflation and increase in increments of $500 – so in future years the limit will rise as inflation does.

Employees over the age of 50 (at any time during the calendar year) may contribute an additional “catch up” amount. This amount is $5,500 in 2013 and follows the same inflation indexing rules as the base limit.

A Lesser known limit exists for the sum total of contributions from both the employee and the employer match. This limit is 10o% of the employee’s gross salary or $51,000 (as of 2013), whichever is lower. (This amount is, you guessed it, indexed for inflation each year).

401k Matching

Some employers offer “matching” on 401k contributions. This match is typically stated in terms of a percentage, i.e. 3%. This means the employer will double your contributions up to 3% of your gross pay. If you made $50,000 annually, the company will match your first $1,500 in contributions to your 401k. A common piece of advice for 401k participants is to take full advantage of this match as it effectively is “free” money.

Vesting

When an employer matches your contributions, it may be subject to a vesting schedule. In simple terms, this means that their contributions are not yours to keep immediately and will “vest” over time, becoming yours. Check out 401K Vesting Schedules for more details.

Enrollment

Enrollment is typically optional and can be done immediately upon your hiring date. However, some employers may require an employee to have been employed for a given period of time before being eligible. If you find yourself in this situation, open an IRA account in the meantime and speak to your HR department about removing the requirement.

In the past few years, automatic enrollment has begun to become more common. This is where the employer will default to enrolling new employees in their 401k plans using a default fund and savings rate. The aim is to make more employees begin planning for their own retirement by making it the default unless an employee specifically opts out.

Withdrawals

Given the tax advantages conferred to 401k plans, there are limits put on withdrawals to encourage employees to keep the funds there for retirement.

Withdrawals from a traditional 401k receive a 10% penalty on top of income taxes applied to the withdrawal unless the employee is 59.5 years old, or a specific exception applies: Death, permanent disability, deductible medical expenses, a QDRO (divorce/separation), or quitting/fired after 55.  A notable exception not listed here is the substantially equal periodic payments “loophole” which can be used by some extreme early retirees.

Loans

Employers may allow employees to take out loans against their 401ks. Loans may not exceed a period of 5 years, and interest paid is applied to the employee’s 401k balance. Payments are made with after-tax dollars. If an employee quits or is fired, the loan must typically be repaid in full within 2 months. If an employee fails to repay the loan at the end of the 5 year term, or after separating from the employer – the balance of loan is considered an early withdrawal and is subject to the penalties and taxes associated with such withdrawals.

Tax Advantages

Given the different tax advantages offered by the two forms of 401k, an employee who has the option may choose one form over the other based on his current income tax rate and his projected income tax rate in retirement. Contributing to a traditional 401k allows the employee to lower his taxable income now, thereby lowering his income taxes and possibly dropping to a lower tax rate. Someone would typically choose this option if they were more likely to have a higher tax rate now than in retirement (which is typical).

A Roth 401k allows the employee to pay the taxes “up-front” and avoid them during withdrawals. An employee would typically find this advantageous if they expected to have a higher income tax rate in retirement than they currently have.

Former Employers’ 401k Plans

If you leave an employer that had a 401k plan you may be “forced out” of the plan if you do not meet a minimum balance requirement. Otherwise you typically have the following options: keep the old 401k at the former employer, roll it over to your current employer’s 401k, or roll it over to an IRA. For more details on rollovers, and my own thoughts on it, see Rollover your old 401k Now!

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