What is a 401(k)?

A 401(k) plan is an employer-sponsored retirement savings plan that offers significant tax benefits. It is a type of retirement plan known as a defined contribution plan. You contribute to the plan via payroll deduction, which can make it easier for you to save for retirement. The essential feature of a 401(k) plan is your ability to make pretax contributions to it. Pretax means that your contributions are deducted from your salary or wages, and contributed to the 401(k) plan, before paying federal (and most state) income taxes. Therefore, pretax contributions reduce your taxable income. You don’t pay income taxes on the amount you contribute, or any investment gains, until you withdraw these funds.

For example, Melissa earns $130,000 annually. She contributes 10% or $13,000 of her pay to her employer’s 401(k) plan on a pretax basis. As a result, Melissa’s taxable income is now $117,000. She isn’t taxed on her contributions ($13,000), or any investment earnings until she receives a distribution from the plan.

You may also be able to make Roth contributions to your 401(k) plan. Using a Roth 401(k) makes contributions on an after-tax basis, just like Roth IRA contributions. Unlike pretax contributions to a traditional 401(k) account, there’s no up-front tax benefit. Your contributions are deducted from your pay and contributed to the plan after withholding for taxes. A distribution, however, from your Roth 401(k) account is entirely free from federal income tax if the distribution is qualified, as discussed below.

Today, most 401(k) plans let you direct the investments held in your 401(k) account. Your employer will provide a menu of investment options and it’s your responsibility to choose the investments. You’ll want to make sure the investments you select align with your retirement goals and financial plan.

When Can I Contribute to a 401(k)?

You can contribute to your employer’s 401(k) plan as soon as you’re eligible to participate under the terms of the plan rules. In general, a 401(k) plan can make you wait up to a year before you’re eligible to contribute. Many plans, however, don’t have a waiting period at all, allowing you to begin contributing as soon as your first paycheck.

Some 401(k) plans provide for automatic enrollment once you’ve satisfied its eligibility requirements. For example, the plan might automatically enroll you at a 3 percent pretax contribution rate unless you elect a different deferral percentage, or choose not to participate in the plan at all. This is called a “negative enrollment” because you haven’t affirmatively elected to participate. Instead, you must affirmatively act to change or stop contributions. If automatically enrolled in your 401(k) plan, make sure to check that your assigned contribution rate and default investments are appropriate for your circumstances.

How Much Can I Contribute to my 401(k)?

There’s an overall cap on your combined pretax and Roth 401(k) contributions. In 2019, you can contribute up to $19,000 (plus an additional $6,000 if you’re age 50 or older) to a 401(k) plan. If your plan allows Roth 401(k) contributions, you can split your contribution between pretax and Roth contributions any way you wish. For example, you can make $10,000 of Roth contributions and $9,000 of pretax 401(k) contributions.

Keep in mind, however, generally speaking if you contribute to multiple employer’s 401(k), 403(b), SIMPLE, or SAR-SEP plans, your total contributions to all of these plans, both pretax and Roth, cannot exceed $19,000 in 2019 ($25,000 if you’re age 50 or older). There are a few circumstances in which you can make contributions to multiple retirement plans, in excess of these limits, but it’s up to you to make sure you qualify to do so.

Can I Also Contribute to an IRA?

Yes. Your participation in a 401(k) plan has no impact on your ability to contribute to an IRA (Roth or traditional). You can contribute up to $6,000 to an IRA in 2019 (plus an additional $1,000 if you’re age 50 or older) if you qualify. But, depending on how much income you earn, your ability to make deductible contributions to a traditional IRA may be limited if you participate in a 401(k) plan.

What Are The Tax Consequences of Using a 401(k) Plan?

When you make pretax 401(k) contributions, you don’t pay current income taxes on those dollars (which means more take-home pay compared to an after-tax Roth contribution of the same amount). Your contributions and investment earnings, however, are taxed as ordinary income when you receive a distribution from the plan. In contrast, Roth 401(k) contributions are subject to income taxes up front. Qualified distributions of your investments are entirely free from taxes. In general, distributions from a Roth 401(k) account are qualified if you wait at least five years to make the distribution and you are at least age 59½, become disabled, or die.

The five-year waiting period for qualified distributions starts on January 1 of the year you make your first Roth contribution to the 401(k) plan. For example, if you make your first Roth contribution to your employer’s 401(k) plan in December 2019, your five-year waiting period begins January 1, 2019, and ends on December 31, 2024.

What About Employer Contributions?

Employers don’t have to contribute to 401(k) plans, but many will match all or part of your contributions. Your employer can match your Roth contributions, your pretax contributions, or both. But your employer’s contributions are always made on a pretax basis, even if they match your Roth contributions. That is, your employer’s contributions, and investment earnings on those contributions, are always taxable to you when you receive a distribution from the plan.

Should I Make Pretax or Roth 401(k) Contributions?

Assuming your 401(k) plan allows you to make Roth 401(k) contributions, which option should you choose? It depends on your situation. If you think you’ll be in a similar or higher tax bracket when you retire, Roth 401(k) contributions may be more appealing, since you’ll effectively lock in today’s lower tax rates. However, if you think you will be in a lower tax bracket when you retire, or if you’re already being taxed at high ordinary income rates, pretax 401(k) contributions may be more appropriate. Your time horizon, investment expectations, and other financial resources are also important factors. A financial planner can help you determine which course is best for you.

Whichever you decide, Roth or pretax, make sure you contribute as much as you can and make it your goal to reach the maximum if possible. At the very least, contribute as much as necessary to receive the maximum matching contribution from your employer if they offer one. Receiving a match or profit sharing contribution from your employer is essentially a retirement bonus that can help you reach your retirement goals that much sooner.

What Happens to my 401(k) When I Terminate Employment?

When you terminate employment you generally forfeit any employer contributions that haven’t vested. Vesting means that you own the money. Your contributions, pretax and Roth, are always 100 percent vested. However, your 401(k) plan may require up to 6 years of service before you fully vest in employer matching contributions. Some plans have a much faster vesting schedule or immediate vesting. Be sure to check your Plan Document or Summary Plan Description for information specific to your 401(k) plan.

When you terminate employment, you can generally leave your money in your 401(k) plan until the plan’s normal retirement age (typically age 65) if your account balance exceeds $5,000, or you can rollover your 401(k) account tax-free, without penalty into an IRA or another employer’s retirement plan.

What Else Do I Need to Know About my 401(k)?

Payroll deductions can make saving for retirement simpler. The money is then “out of sight, out of mind.” Certain 401(k) plans may offer features allowing you to borrow up to one half of your vested 401(k) account, not to exceed $50,000. You may also be able to make a hardship withdrawal if you have an immediate and substantial financial need.

However, this should be a last resort. Hardship distributions are taxable to you (except for your Roth and any other after-tax contributions), and may suspend you from plan participation for six months or more. If you receive a distribution from your 401(k) plan before you turn age 59½ (55 in some cases), the taxable portion may be subject to a 10 percent early distribution penalty by the IRS, unless an exception applies.

Depending on your income, you may be eligible for an income tax credit of up to $1,000 for amounts contributed to the 401(k) plan. Your assets are generally fully protected in the event of your, or your employer’s, bankruptcy.

The Bottom Line

Participate in your employers 401(k) plan and consider enlisting the guidance of a fiduciary financial planner to help you make important decisions about your 401(k) and the effect on your long term goals and financial plan. Everyone has a unique financial situation that requires specific advice and recommendations.