401(k) Basics

Shawn Plummer, CRPC

Chartered Retirement Planning Counselor

Understanding Traditional 401(k) and Roth 401(k) Plans

A 401(k) is a retirement savings plan offered by employers that allows employees to contribute a portion of their wages to individual accounts. Employers may also contribute to these plans, enhancing the potential growth of the savings.

Traditional 401(k) and Roth 401(k) are the two most common types of 401(k) available. While they share many similarities, there are several key differences between them:

Traditional 401(k)

A traditional 401(k) is an employer-sponsored retirement savings plan where you can contribute a portion of your pre-tax earnings. The contributions reduce your taxable income for the year, providing an immediate tax benefit. Investments grow tax-deferred, meaning you won’t pay taxes on the gains until you withdraw the money, typically in retirement. Withdrawals are taxed as ordinary income, and there are penalties for early withdrawals before age 59½.

Roth 401(k)

A Roth 401(k) is also an employer-sponsored retirement savings plan, but contributions are made with after-tax dollars. This means there’s no immediate tax benefit. However, investments grow tax-free, and qualified withdrawals in retirement are also tax-free, provided you’re at least 59½ and have held the account for at least five years. Unlike a traditional 401(k), you pay taxes upfront, but you won’t owe taxes on your withdrawals later.

Key Differences

  • Tax Treatment: Traditional 401(k) contributions are pre-tax, reducing taxable income now, but withdrawals are taxed. Roth 401(k) contributions are after-tax, with tax-free withdrawals.
  • Tax Benefits Timing: Traditional 401(k) offers immediate tax benefits, while Roth 401(k) offers future tax-free withdrawals.
  • Withdrawal Rules: Traditional 401(k)’s have required minimum distributions (RMDs) starting at age 73, while Roth 401(k) do not have an RMD.

Contribution Limits

The contribution limits for Traditional and Roth 401(k) are the same. For 2024, the contribution limits are:

  • Employee Contribution: Up to $23,000 annually.
  • Combined Employee and Employer Contribution: Up to $69,000 annually.
  • Catch-Up Contribution (Age 50+): Additional $7,500.

Roth vs. Traditional 401(k)

Reasons to Invest in a Roth 401(k)

  1. Tax-Free Withdrawals: Withdrawals in retirement are tax-free, including earnings, if certain conditions are met.
  2. No Required Minimum Distributions (RMDs): Roth 401(k) funds can be rolled over to a Roth IRA, which has no RMDs.
  3. Future Tax Rates: Beneficial if you expect to be in a higher tax bracket in retirement.
  4. Tax Diversification: Balances your tax exposure between traditional and Roth accounts.
  5. High Contribution Limits: The same high contribution limits as traditional 401(k) plans.
  6. Employer Matching: Employers can still contribute, but their contributions go into a traditional 401(k) account.
  7. Growth Potential: Potential for significant growth since earnings are tax-free.
  8. Estate Planning: Roth 401(k) funds can be passed on tax-free to heirs.

Reasons to Invest in a Traditional 401(k)

  1. Tax-Deferred Growth: Contributions and investment growth are tax-deferred until withdrawal.
  2. Immediate Tax Savings: Contributions reduce your taxable income in the year they are made.
  3. Employer Matching: Many employers offer matching contributions, providing additional savings.
  4. High Contribution Limits: Allows for substantial annual contributions.
  5. Automatic Payroll Deductions: Contributions are made automatically, making saving easier.
  6. Loan Option: Potential to borrow from your account in times of need.
  7. Early Withdrawals: Hardship withdrawals may be allowed under certain circumstances.
  8. Catch-Up Contributions: Higher contribution limits are for those aged 50 and older.

Other Types Of 401(k) Plans

Here are a few less common types of 401(k) plans:

Safe Harbor 401(k)

Safe Harbor 401(k) plans are designed to automatically meet certain IRS non-discrimination requirements, which ensures all employees benefit from the plan. Employers are required to make contributions to employees’ accounts, either through matching contributions or a fixed percentage of compensation, and these contributions are immediately vested.

Contribution Limits for 2024:

  • Employee Contribution: Up to $23,000 annually.
  • Combined Employee and Employer Contribution: Up to $69,000 annually.
  • Catch-Up Contribution (Age 50+): Additional $7,500.

SIMPLE 401(k)

The Savings Incentive Match Plan for Employees (SIMPLE) 401(k) is designed for small businesses with 100 or fewer employees. This plan is simpler to administer than a traditional 401(k) and includes mandatory employer contributions. Employees can make salary deferral contributions, and employer contributions are immediately vested.

Contribution Limits for 2024:

  • Employee Contribution: Up to $16,000 annually.
  • Catch-Up Contribution (Age 50+): Additional $3,500.

Solo 401(k)

A Solo 401(k), also known as a One-Participant 401(k), is designed for self-employed individuals or business owners with no employees other than a spouse. This plan allows high contribution limits and combines employee deferral and employer profit-sharing contributions.

Contribution Limits for 2024:

  • Employee Contribution: Up to $23,000 annually.
  • Employer Contribution: Up to 25% of compensation.
  • Total Contribution: Up to $66,000 annually (plus catch-up contribution for those 50+).
  • Catch-Up Contribution (Age 50+): Additional $7,500.

401(k) Plan Comparision

Type of 401(k) PlanEmployee ContributionEmployer ContributionTax TreatmentVestingSuitable For
Traditional 401(k)Pre-taxSelf-employed or business owners with no employees other than a spouseContributions and earnings tax-deferred until withdrawalTypically subject to vesting schedulesAny employer
Roth 401(k)After-taxOptional (matching/discretionary)Contributions are taxed, and withdrawals are tax-free if qualifiedTypically subject to vesting schedulesAny employer
Safe Harbor 401(k)Pre-taxMandatory (matching or non-elective)Contributions and earnings tax-deferred until withdrawalImmediately vestedEmployers wanting to avoid IRS testing
SIMPLE 401(k)Pre-taxMandatory (matching or non-elective)Contributions and earnings tax-deferred until withdrawalImmediately vestedSmall businesses with 100 or fewer employees
Solo 401(k)Pre-tax or after-tax (Roth)Optional (employer profit-sharing)Tax-deferred or tax-free withdrawals (Roth)Immediately vestedSelf-employed or business owners with no employees other than a spouse

Vesting Schedules

A vesting schedule in a 401(k) plan is essentially a timetable that determines when you fully own the contributions made by your employer to your retirement plan. It’s an important concept because it affects how much of the employer-contributed funds you can take with you if you leave the company.

Here are the three common types of vesting schedules:

  1. Immediate Vesting: With immediate vesting, you gain 100% ownership of your employer’s contributions as soon as they are deposited into your account. There is no waiting period, which means the funds remain yours even if you leave the company shortly after receiving the contributions.
  2. Cliff Vesting: Cliff vesting means that you must work for the company for a certain number of years before you become fully vested. You forfeit all employer contributions if you leave the company before this period. Common cliff vesting schedules might require three to five years of service before you own any of the employer contributions.
  3. Graded Vesting: Graded vesting schedules allow you to gain ownership of employer contributions over time gradually. For example, a typical graded vesting schedule might vest you 20% for each year of service, becoming fully vested in five years. If you leave the company before being fully vested, you only keep the portion of the employer contributions for which you are vested.
What Is A 401K, And How Does The Retirement Plan Work

Tips for Investing in a 401(k)

  1. Start Early: Begin contributing to your 401(k) as soon as possible to take advantage of compound interest.
  2. Maximize Employer Match: If your company offers one, contribute enough to get the full employer match.
  3. Regular Contributions: Set up automatic contributions to ensure consistent investment.
  4. Diversify Investments: Allocate your 401(k) funds across various asset classes to spread risk.
  5. Increase Contributions Gradually: Aim to increase your contribution rate annually, especially after raises.
  6. Take Advantage of Catch-Up Contributions: Make additional catch-up contributions if you’re 50 or older.
  7. Understand Vesting Schedules: Know when your employer contributions fully become yours.
  8. Avoid Early Withdrawals: Avoid penalties and taxes by not withdrawing funds before age 59½.
  9. Review and Rebalance: Regularly review your portfolio and rebalance to maintain your desired asset allocation.
  10. Consider Roth 401(k) Option: If available, evaluate whether a Roth 401(k) suits your tax situation.
  11. Stay Informed: Keep up with 401(k) regulations and benefits changes.
  12. Monitor Fees: Be aware of the fees associated with your 401(k) investments and try to minimize them.
  13. Plan for Retirement: Estimate how much you’ll need in retirement and adjust your contributions accordingly.
  14. Take Advantage of Loans Cautiously: If your plan allows loans, use them only for essential needs and understand the repayment terms.
  15. Seek Professional Advice: Consult with a financial advisor if you’re unsure about investment choices or strategies.

What We Recommend

When it comes to securing your financial future, starting early with your 401(k) contributions is key. By beginning as soon as you’re eligible, you allow your investments more time to grow through the power of compounding interest. Make it a habit to contribute regularly. Even small amounts can build up significantly over time.

Don’t miss out on what is essentially free money from your employer. Always contribute at least enough to get the full match your employer’s 401(k) plan offers. This match is a part of your compensation package, and not utilizing it fully is like leaving money on the table.

As your career progresses and your salary increases, try to increase the amount you contribute to your 401(k). Adjusting your contributions in line with salary hikes helps ensure that your retirement savings grow in tandem with your earning capacity. Consider periodic reviews of your financial situation to see if you can afford to contribute more, especially when your cost of living adjustments or other financial improvements occur.

Remember, the steps you take today to enhance your 401(k) can significantly impact your comfort and stability in retirement. For tailored advice on optimizing your 401(k) contributions or to get a detailed plan that fits your unique financial circumstances, don’t hesitate to contact us. Our team is here to provide you with personalized guidance and solutions.

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Questions From Our Readers

Can I contribute 100% of my salary to my 401(k)?

In 2024, the maximum contribution for employees under 50 is $23,000. If you’re 50 or older, you can make a catch-up contribution of up to $7,500 for a total potential contribution of $30,500.

How much can a 401(k) earn?

While individual returns may vary, historical stock market returns have averaged around 7% annually after inflation. Consistently contributing and taking advantage of employer matches can maximize the growth potential of your 401(k).

Can I lose money in 401(k)?

Yes, your 401(k) can lose money because it typically invests in stocks, bonds, and other securities, which can fluctuate in value. While markets generally grow over time, short-term losses can occur due to market volatility. It’s important to choose a diversified investment mix aligned with your risk tolerance and retirement timeline to manage potential risks effectively.

What are some alternatives to a 401(k)?

Some popular alternative retirement accounts are IRAs, pensions, deferred annuities, and index universal life insurance.

Does employer match count toward the 401(k) limit?

Employer matching contributions do not count toward your individual 401(k) contribution limit. However, they do count toward the overall limit for total contributions to your 401(k) plan, which includes your contributions, employer matches, and other employer contributions. For 2024, the total contribution limit is $69,000 (or $76,500 if you’re 50 or older).

How much should I contribute to my 401(k)?

Contribute as much as you can without reducing your cost of living or significantly decreasing your current lifestyle. Aim to contribute up to the employer’s maximum match.

What is the average match of a 401(k) by an employer?

The average 401(k) match by employers is typically around 3% to 6% of an employee’s salary, with many employers matching up to 50% to 100% of employee contributions up to that limit.

Shawn Plummer, CRPC

Chartered Retirement Planning Counselor

Shawn Plummer is a Chartered Retirement Planning Counselor, insurance agent, and annuity broker with over 14 years of first-hand experience with annuities and insurance. Since beginning his journey in 2009, he has been pivotal in selling and educating about annuities and insurance products. Still, he has also played an instrumental role in training financial advisors for a prestigious Fortune Global 500 insurance company, Allianz. His insights and expertise have made him a sought-after voice in the industry, leading to features in renowned publications such as Time Magazine, Bloomberg, Entrepreneur, Yahoo! Finance, MSN, SmartAsset, The Simple Dollar, U.S. News and World Report, Women’s Health Magazine, and many more. Shawn’s driving ambition? To simplify retirement planning, he ensures his clients understand their choices and secure the best insurance coverage at unbeatable rates.

The Annuity Expert is an independent online insurance agency servicing consumers across the United States. The goal is to help you take the guesswork out of retirement planning and find the best insurance coverage at the cheapest rates

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