As more Americans shoulder the responsibility of funding their
own retirement, many rely increasingly on their 401(k) retirement
plans to provide the means to pursue their investment goals. That's
because 401(k) plans offer a variety of attractive features that
make investing for the future easy and potentially profitable.
What Is a 401(k) Plan?
A 401(k) plan is an employee-funded savings plan for retirement.
For 2020, you may contribute up to $19,500 of your salary to a
special account set up by your company, although individual plans
may have lower limits on the amount you can contribute. Individuals
aged 50 and older can contribute an additional $6,500 in 2020,
so-called "catch-up" contributions.
How Are 401(k) Plans Taxed?
401(k) plan accounts come in two varieties: traditional and
With a traditional 401(k) plan account, you may defer
taxes on the portion of your salary contributed to the plan until
the funds are withdrawn in retirement, at which point contributions
and earnings are taxed as ordinary income. In addition, because the
amount of your pretax contribution is deducted directly from your
paycheck, your taxable income is reduced, which in turn lowers your
current tax burden.
A Roth 401(k) plan account features after-tax
contributions but tax-free withdrawals in retirement. Under a Roth
plan, there is no immediate tax benefit. However, plan balances
have the potential to grow tax free; you pay no taxes on qualified
One of the biggest advantages of a 401(k) plan is that employers
may match part or all of the contributions you make to your plan.
Typically, an employer will match a portion of your contributions,
for example, 50% of your first 6%. Matching contributions are
maintained in a separate tax-deferred account, which is taxable
when withdrawn. Total contributions, including employee and
employer portions, cannot exceed $57,000 in 2020. Note that
employer contributions may require a "vesting" period before you
have full claim to the money and their investment earnings.
Qualified distributions from traditional plan accounts and from
the earnings portion of Roth accounts are permitted after age
59½ (or age 55 if you are separating from service with the
employer from whose plan the distributions are withdrawn), although
there are certain exceptions for hardship withdrawals.
Distributions from employee contributions to a Roth account may be
taken penalty free at any time. If a distribution is not qualified,
a 10% additional federal tax will apply in addition to ordinary
income taxes on all pretax contributions and earnings.
When You Change Jobs
When you change jobs or retire, you generally have four
different options for your plan balance:
- Keep your account in your former employer's plan, if
- Transfer balances to your new employer's plan;
- Roll over the balance into an IRA;
- Take a cash distribution.
The first three options generally entail no immediate tax
consequences; however, taking a cash distribution will usually
trigger 20% withholding, a 10% additional federal tax if taken
before age 59½, and ordinary income tax on pretax
contributions and earnings.
Borrowing From Your Plan
One potential advantage of many 401(k) plans is that you may
borrow as much as 50% of your vested account balance, up to
$50,000. In most cases, if you systematically pay back the loan
with interest within five years, there are no penalties assessed to
you. If you leave the company, however, you may have to pay back
the loan in full, depending on your plan's rules. In addition,
loans not repaid to the plan by the due date of your federal tax
return are considered withdrawals and will be taxed and penalized
Most plans provide you with several options in which to invest
your contributions. Such options may include stocks for growth,
bonds for income, or cash equivalents for protection of principal.
This flexibility allows you to spread out your contributions, or
diversify, among different types of investments, which can help
keep your retirement portfolio from being overly susceptible to
different events that could affect the markets.
- Pretax contributions and tax-deferred earnings on traditional
- Tax-free withdrawals for qualified distributions from
- Choice among different asset classes and investment
- Potential for employer matching contributions
- Ability to borrow from your plan under certain
A 401(k) plan can become the cornerstone of your personal
retirement savings program, providing the foundation for your
financial future. Consult with your plan administrator or financial
advisor to help you determine how your employer's 401(k) plan could
help make your financial future more confident.