What is a 401K?
A 401(k) plan is a retirement savings plan sponsored by employers, allowing employees to contribute a portion of their paycheck into a tax-advantaged investment account. Employees can typically choose from investment options—often mutual funds—selected by the employer.
RETIREMENT PLANS
There are two main types of contributions:
Traditional (pretax): Contributions are made before taxes, reducing taxable income for the year. Taxes are paid upon withdrawal in retirement. Investment gains grow tax-deferred.
Roth (after-tax): Contributions are taxed upfront, but qualified withdrawals in retirement—including investment earnings—are tax-free if the account is held for at least five years and the participant is age 59½ or older.
Employer Match
Employers may contribute to your 401(k) based on your contributions. For example, they might match 50% of contributions up to 6% of your salary. Matches go into a traditional (pretax) 401(k), even if your contributions are Roth.
Vesting
Vesting refers to ownership of employer contributions. Employee contributions are always 100% vested. Employer contributions may require a vesting period, often ranging from 1 to 6 years, before they fully belong to the employee.
Contribution Limits (2021)
- Employees can contribute up to $19,500 annually.
- Those age 50+ can make an additional $6,500 catch-up contribution, for a total of $26,000.
- Contributions beyond the limit (often due to job changes) must be corrected to avoid penalties.
401(k) Loans21
If allowed by the plan, employees can borrow up to the lesser of $50,000 or 50% of their vested balance. Loans must usually be repaid within 5 years (longer for home purchases), with interest paid back into the account.
- If you leave your job, repayment may be due immediately or within 60 days via a rollover.
- Failure to repay results in the loan being treated as a withdrawal, subject to taxes and a 10% penalty if under age 59½.
Hardship Withdrawals
Hardship withdrawals may be allowed for urgent financial needs like buying a home, education, medical bills, or preventing eviction. These withdrawals:
- Are taxable and may be penalized if under 59½.
- Cannot exceed the amount needed and may restrict future contributions for a period.
Withdrawals & Required Minimum Distributions (RMDs)
- Penalty-free withdrawals begin at age 59½.
- RMDs must start by April 1 following the year the participant turns 72 or retires (whichever is later), unless they own 5% or more of the company.
- RMDs are based on account value and IRS life expectancy tables. Missing an RMD triggers a 50% penalty on the amount not withdrawn.
Why RMDs Exist
- RMDs ensure retirement funds are eventually taxed and not left to grow tax-free indefinitely.
