As a component of benefits offered to employees, 401k plans are a very popular way to accumulate tax-deferred income and earnings for retirement.
Employers offer 401k plans as a way to help their employees save for retirement. You choose how much pre-tax income you wish to contribute and that amount is automatically deducted from your paycheck and placed into your account within the 401k plan. Your retirement savings can continue to grow tax-deferred until you make a withdrawal. You do not pay taxes on your salary deferrals or earnings until you take a withdrawal from the plan. Generally, if you take the distribution after age 59½ there is no tax penalty.
One difference from an IRA is that 401k plans permit higher contribution limits and are only available through your employer.
Because your employer sponsors the 401k plan, there may be other valuable benefits offered in addition to salary deferrals. Check your plan carefully. The following are key features provide a brief overview to assist you:
- Optional Participation: Although some plan sponsors automatically enroll employees to promote plan participations, 401k plan participation is still optional. Check with your employer to determine how you can enroll.
- Contribution Rate: You can choose the amount you want to contribute each payroll up to established IRS limits. You will also be permitted to change your contribution rate once you are in the plan.
- Your 401k plan contribution comes out of your paycheck on a pre-tax basis which lowers your taxable income for that pay period. (That’s a good thing!)
- Available Investments: You can choose from a variety of investment choices selected by your employer.
- Deferred Taxes: Not only do your pre-tax contributions help lower your taxable income each pay period, but all earnings on your contributions grow tax deferred. Note: Some plans offer a Roth 401k, which permit savings on an after tax basis.
- You will not be taxed on either the contributions or earnings until you make a withdrawal.
- Optional Employer Match: To provide an extra boost to retirement savings, many employers match a percentage of an employee’s contribution which will be given to the employee once she is vested.
- Accessing Funds During Employment: Loans—As an optional feature your employer may permit you to borrow against your plan account up to specified IRS limits. Hardship Withdrawals—Understanding that certain hardships arise, the IRS permits plans to allow distributions for certain hardship reasons.
- Portability: If you leave your job, you can remain in the plan or rollover your 401k funds into an IRA or another 401k.
- Support: Your 401k plan provider typically offers many free tools and resources to help you establish savings goals, measure your progress, and to see how financially close you are to meeting your retirement goals.
- The 457 and 403b plans are similar to 401k plans, but are typically offered by other types of organizations. The 457 plan is offered to employees of state and local governments. The 403b plan is offered only to the employees of public schools and qualified tax-exempt organizations such as higher-education, churches, tax-exempt hospitals, and charities.
- Roth accounts: May also be offered by a plan sponsor under 401k, 403b, or governmental 457b plans. Roth contributions are made after you’ve paid taxes on the income, but qualified distributions may be taken tax-free in retirement.1
The 401k is a key financial tool for almost anyone trying to save as much as possible for their retirement.
- You must be employed by a plan sponsor offering a 401k plan to participate.
- If you leave employment, you will no longer be able to contribute to the plan.
- Some employers will let you keep your savings in their plan after you leave.
- You can always combine all of your old plans into one rollover IRA or in most cases, into the 401k plan offered by your new employer.
- Contributions are deducted from your paycheck up to certain IRS-defined annual limits. Contributions can be designated as a specific dollar amount or percentage of your pay. The contributions are taken before taxes, lowering your current income tax bill. You will owe income taxes when you make a withdrawal from the plan. Withdrawals prior to age 59½ are also subject to a 10% IRS early withdrawal penalty, unless an IRS exception applies.
This material is provided for general and educational purposes only; it is not intended to provide legal, tax or investment advice. All investments are subject to risk. We recommend that you consult an independent legal or financial advisor for specific advice about your individual situation.
The information herein is not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding tax penalties. Taxpayers should seek advice based on their own particular circumstances from an independent tax advisor.
1A qualified distribution of designated Roth contributions is excludable from gross income. A qualified distribution is one that occurs at least five years after the year of the participant’s first designated Roth contribution (counting such first year as part of the five) and is made: - On or after the participant’s attainment of age 59½, - On account of the participant’s disability, or - On or after the participant’s death.
If the distribution is not a qualified distribution, then the accumulated Roth 401k earnings will be subject to tax, and additional taxes may apply. Roth 401k amounts are subject to the same required minimum distribution rules as other contributions made to the 401k plan.
Securities and investment advisory services offered through Voya Financial Advisors, Inc., member SIPC.
Neither Voya nor its affiliated companies provide tax or legal advice. Please consult with your tax and legal advisors regarding your individual situation.