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A 401(k) is an account offered by an employer designed to help employees save funds for retirement.
It differs from a savings account or an IRA (Individual Retirement Account) in that it offers a set of investment opportunities that your employer selects.
With this plan, you can regularly contribute a portion of your income, usually monthly, to buying investments within the 401(k) that go into the account and become available at retirement.
Depending on the type of 401(k) plan you choose to take advantage of, you will either be taxed when you contribute to your 401(k) or when you pull money out.
The 401(k) retirement savings account got its name from the Revenue Act of 1978, where an addition to the Internal Revenue Services (IRS) code was added in section 401(k).
Consequently, 401(k) does not stand for anything except for the section of IRS tax code it was created in.
Traditional 401(k) vs Roth 401(k)
There are two types of 401(k) plans: Traditional and Roth 401(k)s.
The traditional 401(k), named after the relevant section of the IRS code, has been around since 1978.
With this plan, any contributions you make to the 401(k) account will reduce your income taxes for that year and will be taxed when they are withdrawn.
Roth 401(k)s, named after former senator William Roth of Delaware, were introduced in 2006.
Unlike a traditional 401(k), all contributions are made with after-tax dollars and the funds in the Roth 401(k) account accrue tax free.
Typically, employees can take advantage of both plans at the same time, which is recommended among financial advisors to maximize retirement savings.
Because of the way the contribution limits work, it is possible to invest different amounts into each account, even year-to-year, so long as the total contribution does not exceed the set limit.
Contributing to Your 401(k) Retirement Plan
Contributing to a 401(k) plan is traditionally done through one’s employer.
Typically, the employer will automatically enroll you in a 401(k) that you may contribute to at your discretion.
If you are self-employed, you may enroll in a 401(k) plan through an online broker, such as TD Ameritrade.
If your employer offers both types of 401(k) accounts, then you will most likely be able to contribute to either or both at your discretion.
To reiterate, with a traditional 401(k), making a contribution reduces your income taxes for that year, saving you money in the short term, but the funds will be taxed when they are withdrawn.
With a Roth 401(k), your contributions can be made only after taxation, which costs more in the short term, but the funds will be tax free when you withdraw them.
Because of this, deciding which plan will benefit you more involves figuring out in what tax bracket you will be when you retire.
If you expect to be in a lower tax bracket upon retirement, then a traditional 401(k) may help you more in the long term.
You will be able to take advantage of the immediate tax break while your taxes are higher, while minimizing the portion taken out of your withdrawal once you move to a lower tax bracket.
On the other hand, a Roth 401(k) may be more advantageous if you expect the opposite to be true.
In that case, you can opt to bite the bullet on heavy taxation today, but avoid a higher tax burden if your tax bracket moves up.
Check out this article from Forbes to see the IRS tax rate tables for 2020, but remember that they are subject to change.
A smart move may be to hedge your bets and divide your contributions between the two types of IRAs.
If your employer allows you to add funds to both a traditional and Roth 401(k), then doing so reduces the potential risks of each.
In this case, you will also have the ability to decide what proportion of your income goes into each account, meaning that as you near retirement and have a clearer idea of what position you will be in, you can put more into one or the other.
When you do decide which avenue to take, make sure to thoroughly evaluate your decision.
Moving funds from one account to another, such as from a traditional to a Roth 401(k), is time consuming and expensive, if even possible.
Likewise, transferring a 401(k) from one employer to another in the event of a job change is also tricky.
You want to make sure that when you put money into your plan, it will be able to sit undisturbed for a very long time.
Pension vs 401(k)
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Pensions are similar to a 401(k), but are a liability to a company.
If an employer offers an employee a pension, it means that they are promising to pay out a set amount of money to the employee at the time of their retirement.
There is typically no option to grow this amount, but it also does not require any financial investment from the employee.
Pensions, also referred to as defined-benefit plans, are becoming increasingly rare because it puts the financial burden of offering a retirement fund for employees entirely on the employer.
401(k)s, which are also called defined-contribution plans, take some of the financial pressure off of an employer, while also allowing employees to potentially earn a larger retirement package than they would have with a pension.
How Much Should I Contribute To My 401(k)?
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Most financial experts say you should contribute around 10%-15% of your monthly gross income to a retirement savings account, including but not limited to a 401(k).
There are limits on how much you can contribute to it that are outlined in detail below.
There are two methods of contributing funds to your 401(k).
The main way of adding new funds to your account is to contribute a portion of your own income directly.
This is usually done through automatic payroll withholding (i.e. the amount that you wish to contribute, counting all adjustments for taxation, is simply withheld when receiving payment and automatically put into a 401(k)).
The system mandates that the majority of direct financial contributions will come from your own pocket.
It is essential that, when making contributions, you consider the trajectory of the specific investments you are making to increase the likelihood of a positive return.
The second method comes from deposits that an employer matches.
Usually employers will match a deposit based on a set formula, such as 50 cents per dollar contributed by the employee.
However, employers are only able to contribute to a traditional 401(k), not a Roth 401(k) plan.
This is especially important to keep in mind if you want to utilize both types of plans.
A key variable to keep in mind is that there are set limits for how much you can add to a 401(k) in a single year.
For employees under 50 years of age, this amount is $19,500, as of 2020. For employees over 50 years of age, the amount is $25,000.
If you have a traditional 401(k), you can also elect to make non-deductible after-tax contributions.
The absolute limit, counting this choice and all employer contributions, is $57,000 for employees under 50, and $63,000 for those over 50 as of 2019.