With every bull and bear, each uptick or downturn in the market, you’re sure to hear someone say something about the fortunes of their 401(k). (Pro tip: the only time this can matter is when you are closing out your 401(k); otherwise, the current state of your 401(k) is just a snapshot of a moment in time.) Chances are, your 401(k) is doing fine. But it’s best to know more about your 401(k) and why it’s good to have one. If you need help deciding about a 401(k) and its options, see a financial adviser.
How Does It Work?
A 401(k) is what’s known as a defined-contribution plan. This means the employee and employer can make contributions to the account up to the dollar limits set by the Internal Revenue Service, since money put in a 401(k) is not subject to taxation until it is withdrawn. By contrast, a traditional pension is a defined-benefit plan, which means the employer is responsible for providing a specific amount of money to the employee upon retirement. Defined-benefit plans place the investment and longevity risk on the plan provider.
In recent decades, as employers have shifted the responsibility and risk of saving for retirement to their employees, 401(k) plans have become more common while traditional pensions have become increasingly rare.
Defined-contribution plans such as a 401(k) place the investment and longevity risk on individual employees, asking them to choose their own retirement investments with no guaranteed minimum or maximum benefits. Employees assume the risk of both investing poorly and outliving their savings. Employees are also responsible for choosing the specific investments within their 401(k) accounts from the selection their employer offers. Those offerings typically include an assortment of stock-and-bond mutual funds, as well as target-date funds with a mixture of stocks and bonds appropriate in terms of risk for when that person expects to retire. They may also include guaranteed investment contracts (GICs) issued by insurance companies and sometimes the employer’s own stock.
The IRS limits the amount you can invest in a 401(k). In 2019, the contribution limit for a 401(k) was $19,000, up from $18,500 in 2018. However, people 50 or older who expect to hit this 401(k) elective deferral limit can contribute an additional sum of up to $6,000, for a total of $25,000. This additional top-up payment is known as the catch-up contribution limit. If the employer also contributes—or if the employee elects to make additional, non-deductible after-tax contributions to their traditional 401(k) account—the total employee/employer contribution for workers under 50 is capped at either $56,000 or 100% of employee compensation, whichever is lower. For those 50 and over, the limit is $62,000.
Both traditional and Roth 401(k) owners must be at least age 59½, or meet other criteria spelled out by the IRS, such as being totally and permanently disabled, when they start to make withdrawals. The recently passed SECURE Act likewise permits penalty-free withdrawals of $5,000 from 401(k) accounts to defray the costs of having or adopting a child. Otherwise, those making withdrawals before reaching age 59½ will face an additional 10% early-distribution penalty tax on top of any other tax they owe.
Both types of accounts are also subject to required minimum distributions, or RMDs. (Withdrawals are often referred to as “distributions” in IRS parlance.) The new SECURE Act also pushes the age at which retirement plan participants are compelled to take required minimum distribution (RMD) from 70½ to 72. (This requirement applies only to those who are not 70½ by the end of 2019). By pushing back the RMD start date, the SECURE Act adds time to allow IRAs and 401(k)s to grow without being depleted by distributions and taxes. For more on the SECURE Act, see our Bowen Reports post on the legislation.
What Are the Benefits?
The advantages of a 401(k) begin with the fact that regular contributions are on a pretax basis. Because of that, the amounts you add to your plan up to that $19,000/$25,000 limit are exempt from current federal income tax, which means they lower your taxable income for the year in which contributions are made. To literally compound the benefit, your 401(k) earnings accrue on a tax-deferred basis. That means the dividends and capital gains that accumulate inside your 401(k) are also not subject to tax until you begin withdrawals.
Besides allowing these funds to grow tax-deferred, when you contribute to a 401(k) plan—or any other qualified retirement plan, for that matter—you also get the benefit of reducing your taxable income by the amount of your contribution. For example, if your salary is $100,000 and you contribute $19,000 to a retirement account, your taxes will be calculated on a taxable income of $81,000. This is a simplification, but if your tax rate was 30% in both cases, then you would be saving $5,700 in taxes from your contribution—and possibly more if the contribution lets you to drop to a lower tax bracket.
Not having access to these funds without penalty is certainly a drawback, but the benefits accrued over time should make up for the reduced flexibility. Thus, make sure that you still save enough money elsewhere for emergencies and expenses you may have along the way to retirement. However, at a minimum, you should contribute the amount that maximizes the company contribution.
How Do You Choose?
Deciding how to invest your retirement savings can be exciting or overwhelming depending on your perspective. The options are more limited within company-sponsored retirement plans than with an IRA. Most 401(k) plans offer investments designed for very different purposes. Some will be aggressive stock funds geared toward maximizing long-term gains, but others will be conservative funds holding mostly bonds and cash. These funds are designed to minimize losses and, as a result, will generate a much smaller annual gain. That’s good if you’re close to retirement, but not so good if you have 30 years to invest.
Different portfolios with different levels of risk and expected return are offered. The key is to get each participant into the correct portfolio based on his or her goals, timing, and risk-tolerance. Also, consider the fees within each portfolio. Target-date funds tend to have higher fees than passively managed funds. With these managed portfolios, the participants understand the expected rate of return and the range of returns. As the participant gets closer to retirement, they move from one model to the next.
More and more 401(k)s are allowing holders to contribute with after-tax dollars. For workers just starting out, taking the tax hit on their retirement savings makes a lot of sense because they have a lot of upside income-potential. That way, all after-tax contributions grow tax-free forever and can be withdrawn tax-free starting age 59½ (as long as the plan has been held for at least five years).
A caveat: even if you choose a Roth 401(k) option, all employer contributions to your 401(k) will be made on a tax-deferred basis. This is a requirement from the IRS. How exactly does this work? If you have a Roth 401(k), employer contributions will go into a separate traditional 401(k), whereas your own contributions will be in the post-tax Roth account. When you withdraw, the funds in the Roth 401(k) account won’t be taxed, but the funds in the traditional 401(k) account will be taxed.
A traditional 401(k) is best if:
- You’re a high earner whose tax bracket is probably higher than it will be when you retire.
- Reducing your taxable income by the amount of your contribution would put you in a lower tax bracket.
A Roth 401(k) is best if:
- You’re a low earner whose tax bracket will probably be higher when you retire.
- You think that policy changes will make tax rates overall much higher when you retire. For example, you predict that the same income taxed at 20% today will be taxed at 40% when it’s time for you to retire.
A third option is to put half of your contribution in a traditional and half in a Roth. It is very difficult to guess what tax rates will be in the future, especially if you are young, in which case you are trying to anticipate tax rates decades away.
If you don’t stay with your employer forever, don’t worry. You’ll likely have the option to take your 401(k) with you to your next job. If not, you can roll it over into an IRA when you leave.
Whether you have a traditional 401(k), a Roth 401(k), or both, it is important to understand what options for investments you have chosen. It’s also important to review the options annually. As always, if you need help, seek a financial adviser.
Disclaimer: While this article may concern an area of investing or investment strategy in which we supply advice to clients, this document is not intended to constitute a complete description of our investment services and is for informational purposes only. It is in no way a solicitation or an offer to sell securities or investment advisory services. Any statements regarding market or other financial information is obtained from sources which we and/or our suppliers believe to be reliable, but we do not warrant or guarantee the timeliness or accuracy of this information.
Past performance should not be taken as an indicator or guarantee of future performance, and no representation or warranty, express or implied, is made regarding future performance. As with any investment strategy or portion thereof, there is potential for profit as well as the possibility of loss. The price, value of and income from investments mentioned in this report (if any) can fall as well as rise. To the extent that any financial projections are contained herein, such projections are dependent on the occurrence of future events, which cannot be predicted or assumed; therefore, the actual results achieved during the projection period, if applicable, may vary materially from the projections.