Tax-Deferred Accounts Part One: 401(K) Accounts – What They Are and Why They’re Beneficial

Have you ever thought about how you will support yourlifestyle after retiring? Are you looking for retirement plans but can’t seemto make head and tail of them? Our guide breaks down the basics of Americans’most common retirement plan: the 401(k).

This account allows you to contribute to your retirement sothat – if used properly – enable you to have a nice nest egg by the time youretire and no longer work. You need to understand the basics of a 401(k) tounderstand better how it works and make the most of it.

What is a 401(k) plan?

The 401(k) gets its name from the section of the UnitedStates Internal Revenue Code pertaining to so-called “Cash or DeferredArrangements.” The most important part of Section 401(k) pertains to so-calledDefined Contribution accounts.

As the name implies, a Defined Contribution account is onewhereby an employee directs a certain portion of one’s gross income to be contributeddirectly to an account specifically designed for retirement purposes.  Because a 401(k) account is centered onpre-tax contributions, such an account is typically offered through one’semployer.

Unlike the retirement amounts afforded to retirees of traditionalpension plans,  the size of one’sretirement in a 401(k) account will be determined principally by how theemployee contributes and invests his or her account.  This has major implications for how one needsto and should manage one’s 401(k) account.

What is a traditional 401(k)?

The most commonly available 401(k) plan is the traditional401(k). The payments made to these plans offer a respite from having to paytaxes immediately. This means that the payment to your retirement is deductedfrom your entire income before any tax is charged on it.

For instance, let’s suppose Sally has a gross income of $50,000in Tax Year 2021 and decides to contribute $10,000 to her traditional 401(k)account.  Because the $10,000contribution is treated as a pre-tax contribution, Sally’s preliminary* taxableincome is only $40,000.  If Sally’seffective tax rate is 40%, then this represents a savings of taxes in 2021 of$4,000.

*(Note: Sallymay have other deductions and credits, so the final taxable amount may verywell be lower than $40,000.)

When Sally retires and starts taking withdrawals from her401(k) account, the entire amount is fully taxable at ordinary income rates.

What is a Roth 401(k)?

A Roth 401(k) came into play sometime after the traditionalone, which is why many employers still do not offer it.  In a Roth 401(k) account, the contributionscome from after-tax money rather than the pre-tax money used for atraditional 401(k) contribution.

While Roth 401(k) accounts do not provide tax benefits todaythey provide tax benefits in the future as any withdrawals duringretirement are exempt from income tax; this includes both thecontributions and the growth in those contributions.  In other words, a Roth 401(k) account holderwho makes withdrawals will be entitled to keep 100% of the amounts of thosewithdrawals.

Can you contribute to both plans?

Yes, some employers offer the option of contributing to bothtraditional and Roth 401(k) plans. However, there are two things you shouldknow beforehand. Firstly, most employers do not offer a Roth plan in the firstplace.

Secondly, even if you choose to split your contributionsbetween these two separate plans, you will still have to observe the maximumlimit that applies to a single account: for most individuals, $19,500 for TaxYear 2021 and $20,500 for Tax Year 2022. (Future year amounts are typically indexed to inflation and rounded tothe nearest $500.)

Whether you should contribute to a Traditional or Roth401(k) depends on your personal preference to a large extent. If you arelooking for some immediate savings, the traditional option is more suited sinceyou have to pay lesser tax on your income.

However, if you do not need such a benefit, you may considermaking your retirement as hassle-free as possible and opt for the Roth 401(k) plan,where you pay taxes now and make tax-free withdrawals later.  Please reach out to us to discuss about whichplan you should invest in from trained experts.

What is “Employer Matching” in a 401(k) Plan?

Employer Matching is a benefit many companies make totheir employees who contribute to 401(k) accounts.  This is like a bonus: instead of getting itimmediately, you can cash it at a later time.  While not all companies offer EmployerMatching, if your company does, you should take maximum advantage of it bycontributing the maximum matching percentage.

Some employers may match every dollar you contribute with adollar of their own, while others may give 50 cents for every dollar you make.

Others might offer a hybrid of the two matching schemes: Anemployer might contribute dollar-for-dollar up to a certain percentage and thengive 50 cents for every dollar above a certain percentage.

Consider the case of Tom, an employee who works for Jerry,Inc. (“Jerry”), who offers the following hybrid matching scheme: Jerry willmatch Tom’s contributions dollar-for-dollar up to 3% and 50 cents on the dollarbetween 3% and 5%.  Tom should contribute(at a minimum) 5% to take full advantage of Jerry’s match; Jerry will match 4%of Tom’s contributions (calculated as dollar-for-dollar on the first 3% plus50% of the 2% between 3% and 5%).

So in a partial matching scheme, you may qualify formatching if 6% of your earnings go to the 401(k). Since your employer onlymatches 50 cents per dollar, for the 6% you contribute, 3% of your income isalso contributed by your employer.

Can I choose where my money is invested?

Generally speaking, you will have significant say in howyour money is to be invested, but unlike a traditional brokerage accountwhereby you will have thousands – maybe even tens of thousands – of investmentoptions, most 401(k) plans only offer a couple of dozen choices.  These options are typically diversified stockand bond mutual funds, as well as a cash-equivalent option such as a moneymarket fund.

One investment option that has become increasingly prominentin 401(k) plans over the past decade or so is that of so-called Target-DateRetirement Funds.  These funds arepopular because they simplify the sometimes complex process of deciding whichfunds to invest in to a single question: “In which year do I plan onretiring?”  The employee can then put allof his/her contributions into the Target Date fund with a year closest tohis/her anticipated year.

Only in rare cases will options include more “sexy” optionssuch as individual stocks or exotic assets like Options orCryptocurrencies.  One notable exceptionis that some companies will offer employees to invest in the individual stockof the company.  For example, WidgetInc., might permit employees in its 401(k) plan to invest in Widget stock.

How does the money in my 401(k) grow?

The money in your 401(k) can increase over time depending onthe kind of investments you make. Your 401(k) money will be invested acrossvarious stock options, and the money that the stock makes goes to your account.

The success of your 401(k) account over time will bedirectly correlated to the types of asset classes in which you invest.  Generally speaking, higher returns willaccrue to those accounts invested in Equities (i.e. Stocks) with lower returnsto those accounts invested in Fixed Income (i.e. Bonds and Cash).  More balanced portfolios – those investing ina mixture of Equities and Fixed Income – will have returns somewhere inbetween.

Is there a limit to how much you can contribute?

As indicated earlier, a traditional 401(k) account does havea maximum amount to how much you can contribute on an annual basis: $19,500 inTax Year 2021 and $20,500 in Tax Year 2022.

However, people who are 50 or above are allowed to make aso-called catch-up contribution, enabling an individual who is – forexample – 55 years old to contribute up to $26,000 in Tax Year 2021 and $27,000in Tax Year 2022.   This means that olderworking people are allowed to make larger contributions since their retirement isnearing, and they need to save money before they reach that point.

Do you need to withdraw money from a 401(k)?

The IRS does require you to withdraw a certain amount fromyour retirement accounts. These are known as Required Minimum Distributions(“RMDs”), and these must be made from a traditional 401(k) account when youreach the age of 72 for most individuals.

If, however, you are still working at the age of 72 – whichis increasingly occurring – you might be exempt from making these RMDs.

When can you withdraw money from a 401(k)?

According to the rules laid down by the IRS, the minimum ageone can withdraw money from a 401(k) account is 59.5 years without incurringany penalties. This is because, in most cases, a handsome amount of savingshave already been accumulated into the account, making it practical to withdrawthe money.

You can also withdraw money from this account if you fulfillother requirements laid down by the IRS, such as being disabled. This isbecause the whole purpose of 401(k) is to help you when you need it, and theseconditions will usually make you eligible for these withdrawals as they mayprove your need.

Can you withdraw money from a 401(k) earlier than normal?

Strictly speaking, it is possible to make withdrawals beforeyou reach the age limit prescribed by the IRS. However, the whole purpose of401(k) accounts is to encourage responsible saving. To prevent people fromchipping away at their savings, you may have to pay a 10% early distributiontax.

This can be a hefty penalty to pay, particularly when youhave to pay your routine taxes as well. This is why we tell our clients to savefor everyday emergencies separately. Just plan your daily expenses and regularsavings based on your income after the 401(k) contribution has been deducted.This will make you better prepared for any problems you may face and allow youto handle them without having to dip into your 401(k).

One way to avoid the penalty payment could be to take a loanagainst your account. Some employers give you the offer of taking a loan.However, there is a strict time limit and usually, a lump sum repaymentcondition that you need to adhere to if you do not want to pay the 10% taxpenalty. 

What are the benefits of a 401(k)?

There are numerous benefits of having a 401(k) account. Thefirst is that your immediately taxable income is reduced in a traditional401(k), so you make immediate savings.

The second plus point is that the deductions arehassle-free: once you sign up for this plan with your employer, he makes thedeductions automatically, and you do not need to worry about anything else.

Thirdly, the earlier you start contributing to a 401(k)account, the more money you saved for retirement. Thinking about such thingsnow will help you at a time when you need it. You will not even feel as if achunk of your income is going to a separate account; you can plan your dailyexpenses around the income you get after the 401(k) income is deducted.

Lastly, and perhaps most importantly, 401(k) accounts areextremely flexible. These accounts can be transferred from one employer toanother, and you can even choose how much to contribute to them.

Summary

As a working American, having a retirement plan isessential. You will not be able to work all your life, and even if you can, youmay not want to. This means that you should have some savings set aside forthis time.

The 401(k) account is one of the best retirement planoptions since it ensures responsible saving. The money is automaticallydeducted, and there is a strong deterrent on immediate withdrawals, securingyour money for a time when you need it.

We provide complementary advice on 401(k) plans for clients who have investment accounts with us.  Please reach out to us to schedule a time to discuss a strategy for investing in your 401(k) plan.

October 08, 2021 RVW Wealth