What Is A 401(K)?

A 401(k) is a type of retirement savings plan offered by many employers in the united states. It was named after a section of the U.S. Internal Revenue Code, this plan is an employer-provided defined-contribution plan. The employer may match employee contributions with some plans which makes the match mandatory.

“401(k)s are into two major types, which are known as traditional and Roth”.

With a traditional 401(k), employee contributions are pretax, meaning they reduce taxable income, but withdrawals in retirement are taxed. You pay taxes on withdrawals when you retire, at your income tax rate at that time.

Employee contributions to Roth 401(k)s on the other hand, are made with after-tax income. There’s no tax deduction in the contribution year. However, withdrawals, including earnings, are tax-free if certain conditions are met, usually after age 59½ and if the account has been open for at least five years.

Let’s Have a Clearer Understanding of:

• How to Start A 401 (K)? (Now, talking about how to start a 401(k) plan, we have to understand and utilize these retirement savings vehicles.
  Firstly, you need to Educate yourself by learning about the plans features, investment options, and rules.)
• Set clear goals by defining your retirement objectives and risk tolerance.
• Contribute consistently to the plan especially if your employer matches contributions.
• Monitor and Adjust by periodically reviewing your account and rebalance your investment.

So, in starting a 401(k) plan, you need to review your plan details, then you decide on how much you want to contribute, and then go ahead to choose your investment, enroll and set up automatic contributions.

How 401(K) Plans Work?

A 401(k) is a retirement savings plan, and the benefits are: tax advantages, employer matching contribution if offered, and compound interest growth.
In the early 1980s, traditional 401(k) plans allow employees to make pre-tax contributions from their salaries up to certain limits. When a worker signs up for a 401(k), they agree to deposit a percentage of each paycheck directly into an investment account. Employers often match part or all of that contribution. Employees are also responsible for choosing the specific investments held within their 401(k) accounts from a selection that their employer offers. Those offerings typically include stock and bond mutual funds and target-date funds designed to reduce the risk of losses as the employee approaches retirement.

Peter Lazaroff who is the financial advisor and chief investment officer at Plancorp, once said “The most important thing to know when making any decision about your 401(k) is to use it”. In a perfect world, you put the maximum amount in it, but at a minimum, you should contribute up to the point where your company matches what you put in.

The salaries of the Americans in 2023 saved an average of 7.1% in their 401(k)s, which was higher than the overall personal savings rate that year. Americans who were Less than 12% of working-age were on track in 2023 to max out their contributions. The 401(k) employee contribution limit for 2024 is $30,500 (including “catch-up” contributions) for those 50 and older and $23,000 for those under 50.

How Do You Start A 401(K)?

Some of you may be having difficulty in starting a 401(k). Well, these are insights on how to get a 401(k) plan started up:

• Contact your employer Ask if a 401(k) is available, and whether there is a company match. If a 401(k) is available, the company will instruct you how to sign up with new paperwork.
• Choose your investments: There should be a range of options, from conservative to aggressive. A popular option is the target date account, which automatically adjusts the asset mix to align with a preset retirement date. It typically becomes more conservative as you near retirement.

Note: If you are self-employed or run a small business with your spouse, you may be eligible for a solo 401(k) plan, also known as an independent 401(k). These plans allow independent contractors to fund their own retirement. A solo 401(k) can be created through most online brokers.

History of The 401(K)

The U.S. has undergone a significant shift in how Americans save for retirement, as illustrated below by our chart comparing the number of Americans (in millions) in defined benefit and defined contribution plans, along with the total for both. Today, 401(k) plans are cornerstone of employer-sponsored retirement benefits, with millions of participants and trillions of dollars in assets. With a pension, the employer is committed to providing a specific amount of money to the employee for life during retirement.

401(k)s have become the most common private employer-sponsored retirement program in the U.S. About a third of working-age Americans have a 401(k), compared with one in nine who have a defined benefit pension plan10. As a result, your taxable income is reduced by the total contributions for the year and can be reported as a tax deduction for that tax year. No taxes are due on the money contributed or the investment earnings until you withdraw the money, usually in retirement.

How Does Your 401k Earn Money?

A 401(k) plan earns money through investment and compound interest. Several factors influence the pace and extent of your 401(k)s growth, including the amount you contribute annually, any company matches, investment performance, and the time until retirement.
A significant benefit of a 401(k) is tax-deferred growth. With a traditional 401(k), you don’t have to pay taxes on investment gains, interest. Opening a 401(k) also allows your money to grow over time, thanks to the power of compounding. Compounding occurs when the returns generated by your savings are reinvested into the account, generating returns of their own. Earnings are reinvested allowing your account balance to grow over time.

401(K) Withdrawals Rules

Once your money goes into a 401(k), it can be difficult to withdraw it without paying taxes on the amount. You can start to withdraw your savings penalty-free when you reach age 59. Taking out your saving at that time could cost you an extra 10%. On top of what you would normally pay in in state and and federal taxes. Make sure that you still save enough on the outside for emergencies and expenses you may have before retirement
Earnings in a 401(k) account are tax-deferred for traditional 401(k) accounts and tax-free for Roth accounts. When you withdraw from a traditional 401(k), that money (which has never been taxed) will be taxed as ordinary income. With a Roth, you’ve already paid income tax on the money you contributed, so you won’t owe taxes on withdrawals if you satisfy specific requirements.

Required Minimum Distributions

Traditional 401(k) account holders have required minimum distributions (RMDs) after reaching a certain age. This is minimum amount that a retirement account owner must withdraw from their account each, starting at a certain age.
Investors who have retired must start taking RMDs from their 401(k) plans at age 73. The amount of the RMD is calculated based on your life expectancy at the time. Before 2020, the RMD age was 70½ years old. Before 2023, it was 72.

The Pros and Cons of A 401(K)

Pros

• Tax Benefits: contributions are made before taxes, reducing taxable income.
• Employer matching: Many employers match contributions, essentially providing free money.
• Compound Interest: Earnings grow Tax-deferred, leading to significant long-term growth.
• Portability: Accounts are portable, meaning you can take them with you if you change jobs.

Cons

• Contribution Limits: Annual contribution limits apply ($20,500 in 2024, plus $6,500 catch-up).
• Investment Risk: investments can fluctuate, and losses are possible.
• Fees and Expenses: Management fees, administrative costs, and other expenses apply
• Penalties for early withdrawal: Withdrawals before age 59 ½ may incur a 10% penalty.

401(K)S Vs. Brokerage Accounts

A brokerage account is a private account where you can buy, sell, and hold whatever securities your broker has access to, including mutual funds, stocks, bonds, and exchange-traded funds (ETFs). Brokerage accounts are taxable, meaning that your capital gains and dividends are subject to tax

Which to Choose?

• For Retirement Savings: If your primary goal is saving for retirement, a 401(k) is usually the better option due to the tax advantages, potential employer match, and higher contribution limits.
• For Flexibility and Diversification: If you want more flexibility in your investments and the ability to access your money without penalties, a brokerage account might be more suitable.
• Combining Both: Many people use both types of accounts. They contribute enough to their 401(k) to get any employer match and then invest additional funds in a brokerage account to take advantage of flexibility and a wider range of investment options.

Your decision may also depend on your current financial situation, tax bracket, and long-term financial goals. It might be helpful to consult with a financial advisor to tailor the best strategy for your needs.

A Real Life Example to Illustrate the Concepts of A 401(K) Plan Using the Character “Alicia”.

Alicia, a 28-year-old marketing professional, starts her first job at a tech company that offers a 401(k) plan. Her starting salary is $60,000 per year. She decides to contribute 6% of her salary to her 401(k), which is $3,600 annually, or $300 per month. Her employer offers a 50% match on contributions up to 6% of her salary.

Since Alicia contributes $3,600 to her traditional 401(k), her taxable income for the year is reduced to $56,400. This lowers her tax bill for the year, providing immediate tax relief. If Alicia had contributed to a Roth 401(k), she would have paid taxes on her $3,600 contribution upfront, but her withdrawals in retirement would be tax-free.

Alicia’s employer contributes $1,800 annually to her 401(k) (50% of the $3,600 she contributed), which is effectively like a bonus for saving. Over time, these contributions from her employer significantly boost her retirement savings. She has access to a range of investment options within her 401(k) plan, including stock mutual funds, bond funds, and target-date funds. She chooses a mix of a target-date fund that aligns with her expected retirement age (around 2055), which automatically adjusts the investment mix as she gets closer to retirement.

Over the next decade, Alicia’s investments grow due to the power of compounding returns. Let’s assume her account earns an average annual return of 7%. After 10 years, her initial $3,600 annual contribution and her employer’s matching contributions have grown to about $56,000. This growth is largely due to reinvested earnings and compound interest.At age 35, Alicia decides to switch jobs. She rolls over her 401(k) balance into an IRA to keep her retirement savings growing tax-deferred. This rollover avoids taxes and penalties and consolidates her retirement funds in one account, making them easier to manage.

By the time Alicia reaches 60, her 401(k) has grown significantly, thanks to continued contributions, employer matches, and market returns. She starts planning for retirement withdrawals, knowing that she will need to begin taking required minimum distributions (RMDs) at age 73 from her traditional 401(k). If she had chosen a Roth 401(k), her withdrawals would be tax-free, giving her more flexibility in managing her retirement income.
Alicia’s experience with her employer’s 401(k) match highlights a critical benefit on her first paycheck. Alicia noticed a small line item labeled “401(k) Match” which showed her employer’s contribution. Initially, it seemed like a minor perk, but over the years, she realized how significant these contributions became. The employer match wasn’t just an extra benefit; it was a crucial part of her overall retirement savings strategy.

And The Key Takeaways from Alicia’s Experience Is:

• Maximize Employer Match: Always contribute enough to get the full match from your employer—it’s essentially free money.
• Tax Benefits: Understand the tax implications of your 401(k) contributions. Traditional 401(k)s reduce your taxable income now, while Roth 401(k)s offer tax-free withdrawals later.
• Long-Term Growth: Consistent contributions and the power of compounding returns can significantly grow your retirement savings over time.
• Portability: If you change jobs, rolling over your 401(k) can help consolidate your retirement savings and continue tax-deferred growth.
• Alicia’s journey with her 401(k) showcases how thoughtful planning and taking advantage of employer benefits can build a solid foundation for retirement savings.

The Bottom Line

A 401(k) plan is a workplace retirement plan that allows you to make annual contributions up to a specific limit and invest that money for your later years after your working days are over. There are two major types of 401(k) plans: traditional or Roth. The traditional 401(k) involves pretax contributions that give you a tax break when you make them and reduce your taxable income. However, you pay ordinary income tax on your withdrawals. The Roth 401(k) involves after-tax contributions and no upfront tax break, but you won’t pay taxes on your withdrawals in retirement. Both accounts allow employer contributions that can increase your savings.