A 401(k) plan is a type of retirement savings account. It is a tax-deferred savings pension account frequently offered for employees by employers. These plans are named for the subsection of the U.S. Internal Revenue Service code they are found under: in this case, 401(k).
In most organizations, 401(k) and other retirement plans are managed by a human resources department as part of a benefits administration. Since the introduction of the 401(k) plan in 1978, it has become the most popular type of retirement fund account sponsored by employers in the United States.
Under a 401(k), contributions made by an employee are deducted from the employee's pay by the employer and placed in a separate account. Plans typically offer investment options and contributions that can be matched by the employer. The plan allows employees to contribute up to $19,500 pre-tax income per year. Barring exceptions, such as the death of an employer or the permanent and complete disability of the employee, a 10% penalty is typically incurred for withdrawals before the age of 59 and a half, much like with Individual Retirement Accounts (IRA), which have a similar purpose.
Due to the pandemic, the 2020 CARES (Coronavirus Aid, Relief, and Economic Security) Act was put into effect to assist individuals negatively affected by COVID-19. It allows qualifying individuals to withdraw up to $100,000 from their account without penalization, take loans of up to 100% of the vested balance or $100,000, defer loan payments for up to a year and spread out withdrawal taxes over three years. Furthermore, required minimum distributions (RMDs) for retirees aged 70.5 and older are not required for the year 2020.
Types of 401(k) plans
There are two main types of 401(k): the traditional and the Roth. The two types differ in tax basis, which is how taxation is applied.
- Traditional 401(k). Contributions from employee paychecks are made pre-tax. Withdrawals (distributions) after retirement are taxed as ordinary income, rather than capital gains. Traditional 401(k) plans can reduce the current tax bracket of account owners.
- Roth 401(k). Contributions come out of the paycheck after taxes, but withdrawals are tax-free. Generally recommended for people who think they will be in a higher tax bracket after retirement than currently.
How does a 401(k) work?
401(k) accounts can only be sponsored by an employer. In most organizations, the 401(k) plan is offered as an optional retirement benefit.
A 401(k) is a defined contribution account. If an eligible employee participates in a 401(k), they will decide an amount of their salary that will be deducted from their paycheck into a separate account.
Employer matching. Employers may or may not match the employee's contributions, up to a limit. Employers who decided to match employee contributions do so according to a determined formula. Employer contributions might be on the basis of $0.50 or $1.00 for every $1.00 contributed by the employee.
Investments. Companies typically offer employees several investment options for their 401(k) accounts. These can include mutual funds, index funds, large- and small-cap funds, real estate funds, bond funds and foreign funds. These options are managed by financial service groups.
For traditional 401(k) accounts, contributions from employee paychecks are made with pre-tax dollars and taxed as ordinary income upon withdrawal. Contributions to Roth 401(k)s are made with post-tax paycheck deductions but are not taxed upon withdrawal.
Withdrawals. Usually, once the money is deposited into a 401(k), employees must meet certain criteria in order to make an unpenalized withdrawal from their 401(k) account (whether traditional or Roth). These criteria are known as triggering events:
- The employee reaches 59.5 years in age.
- The employee retires or leaves the job.
- The employee dies or becomes disabled.
- The employee satisfies plan-specific criteria.
- The plan is terminated.
- The employee is affected by COVID-19 (see "COVID-19 and the 2020 CARES Act").
Early withdrawals that do not satisfy these criteria are typically subject to income taxes and an additional 10% in penalties.
Required minimum distributions. 401(k) plans require retirees aged 70.5 years old to start making withdrawals of a minimum dollar amount. Unlike IRA accounts, this is not applicable if the person is still employed and the account is with their current employer. Required minimum distributions are waived for the year of 2020.
Loans. Employers may or may not allow loans from a 401(k) account. If allowed, up to 50% can be borrowed from the vested balance and usually must be repaid within five years. The limit for loans is $50,000. Interest rates are applicable; any amount of the loan that is not repaid will be considered a withdrawal and taxed and/or penalized.
Rollover. Retirees can opt to transfer 401(k) balances into traditional or Roth IRA accounts, for wider investment choices. There are two types of rollover:
- Direct rollover. The balance is transferred directly from a 401(k) account to a new account. It is not affected by tax.
- Indirect rollover. The balance from 401(k) is moved from the account to its owner, then from its owner to the new account. It is subject to full income taxes.
Limits to 401(k) contributions are put into effect by the IRS and vary by year. Limits to both employee and combined employer/employee contributions exist.
In 2020, the yearly limit for employee contributions is $19,500. For combined employer and employee contributions, the limit is either $57,000 or 100% of employee compensation, whichever is lower.
Employees above the age of 50 are allowed additional catch-up contributions beyond the standard limit. In 2020, the limit for additional catch-up contributions is $6,500.
Further limits exist for employees with high salaries, to make sure the benefits of company plans are distributed proportionally across all income levels. Those who qualify as highly compensated employees (HCEs) receive over $130,000 in compensation or own more than 5% of interest in the sponsoring business during the last year. When lower-income employees do not participate in the company 401(k) plan, more restrictions tend to occur for HCEs.
COVID-19 and the 2020 CARES Act
Due to the COVID-19 pandemic, the Coronavirus Aid, Relief, and Economic Security (CARES) Act was put into effect. Because of the 2020 CARES Act, eligible individuals can now:
- Withdraw up to a limit of either 100% of their vested balance or $100,000 from 401(k) accounts without penalization.
- Have the withdrawal taxed as income spread evenly through 2020, 2021 and 2022.
- Take loans of up to either 100% (up from 50%) of vested balance or $100,000 from their 401(k) accounts. Loan payments can be deferred for up to one year.
- Avoid required minimum distributions, so that account owners are not forced to sell stocks during the pandemic market (applicable to all over the age of 70.5 years).
2020 CARES Act eligibility. Individuals who qualify for COVID-19-related 401(k) lenience must satisfy one of these criteria:
- Have been diagnosed with COVID-19.
- Have a spouse or dependent who was diagnosed with COVID-19.
- Unable to work, from a need to stay home and take care of kids.
- Faced adverse financial consequences related to COVID-19, such as being laid off, furloughed or having hours reduced.
History of 401(k) plans
The 401(k) plan originated in the 1970s as a result of a direct petition of the U.S. Congress by a group of salaried employees from Kodak, the imaging technology company. The group asked Congress allow exemptions on taxes for portions of their salary invested in the stock market. In 1978, the 401(k) was created as a means of easing taxes for investing taxpayers. The common current use as a means to create a tax-deferred savings for retirement was conceived of by attorney and consultant Ted Benna in 1980. Among the roughly two dozen investment options for 401(k) are Roth IRAs and traditional index funds.