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Everything You Need to Know about 401(k) Plans

Everything You Need to Know about 401(k) Plans

Americans are generally expected—and seek to—retire in their 60s. At 62 they can start collecting Social Security, while full retirement age is considered to be 66. As of 2019, the average retirement age among living retirees was 59.88 years old.

Most financial experts maintain that workers should have at least $1 million set aside if they plan to retire in their 60s. However, this isn’t the reality for the average working American. In fact, a 2018 study conducted by Northwestern Mutual found that 21 percent of American workers had no retirement savings whatsoever. One way to get a head start on retirement planning is through an employer-sponsored 401(k) plan.

How to Contribute—and How Much

Contributing to an employer-sponsored 401(k) plan can be very beneficial. This type of plan confers various tax advantages, and contributions are often matched in part or whole by the employer. Earnings on investments made through the plan do not accrue taxes until you make a withdrawal, which is generally after retirement. Moreover, contributions made in a given year can help reduce your income taxes for that year.

You can contribute to your 401(k) plans via automatic payroll withholding, but you are limited to a specific amount as designated by the Internal Revenue Service (IRS). The limit for employee contributions as of 2020 is $19,500 per year for workers younger than 50 and $26,000 for those older than 50. Should employers choose to contribute to these plans, the limits are $57,000 and $63,500 for the aforementioned age groups, respectively.

One key difference between 401(k) plans and traditional pensions is that employees are granted more responsibility in saving for their future. For instance, they are tasked with choosing specific investments from a selection provided by their employer. These may include a variety of stock and bond mutual funds in addition to guaranteed investment contracts and target-date funds.

When to Make Withdrawals

While it’s important to save as much as possible for retirement, you should also make sure you have enough money stashed in a separate account for emergency expenditures. This is necessary because 401(k) withdrawals are subject to a 10 percent early withdrawal fee before you turn 55. After that point, withdrawals can be made penalty-free. However, penalty-free exceptions are granted by the IRS in special circumstances. These involve total and permanent disability, coverage for medical expenses, and military reservists forced into active duty.

Required Minimum Distributions

You can also choose not to withdraw funds from your 401(k) plan and instead allow interest to build until you reach age 72, when required minimum distributions (RMD) begin. The RMD amount each year after 72 is determined by life expectancy at the time and can be calculated by following the IRA Required Minimum Distribution Worksheet offered by the IRS. The American Association of Retired Persons (AARP) also has an RMD calculator on its website.

Considering a 401(k) account balance of $100,000 with an estimated rate of return of 4 percent, a 72 year old would have to make an RMD of $3,906.25 in 2020. This figure increases every year. In 2025, for instance, their RMD would be $4,667. It would reach a peak of $6,482 when the account holder is 93 years old.

Options When Leaving a Company

Saving through a 401(k) plan is relatively simple if you spend your entire career at one company, but this often isn’t the case. If you leave the company where you started an initial 401(k) plan, you have four options. Some companies will permit you to roll over your account to your new employer to avoid immediate taxes and protect your retirement assets. Similarly, you can choose to move the funds into an individual retirement account, or IRA, at a mutual fund company or brokerage firm. The IRS has strict guidelines on facilitating a rollover, but a good brokerage firm will typically ensure it complies with those rules.

Another option is to simply leave the 401(k) plan with your old employer so long as they permit it. However, you will no longer be able to make contributions to these plans.

The last option is to withdraw the money. This should be viewed as a last resort as the withdrawal will be taxable and subject to a 10 percent early distribution tax unless you meet specific requirements.

CARES Act Changes

The COVID-19 global pandemic has altered many aspects of society and business operations in 2020. The $2 trillion CARES Act signed into law by President Donald Trump, for instance, grants additional privileges for 401(k) account holders. Individuals experiencing economic hardship as a result of the pandemic are entitled to a penalty-free $100,000 hardship distribution and have three years, as opposed to one, to pay taxes on withdrawals. Moreover, RMDs were suspended from all retirement accounts.