It is never too soon to learn more about your retirement options. One of the most popular options for retirement savings is utilizing a 401(k) plan in the United States.
A 401(k) is a qualified plan established by your employer that allows you to make contributions on either a post-tax or pre-tax basis. In addition, employers that offer a 401(k) plan may offer to make matching contributions for eligible employees. Also, there are other benefits including that earnings put into a 401(k) account accrue interest through a tax-deferred basis. Before you opt to establish a 401(k) plan and begin your contributions, you will want to gain more information about what a 401(k) plan is, what the contribution limits are, and how you should go about starting the plan. To learn more, read the sections below.
There are multiple different types of 401(k) plans available for employers to implement at their business. These types include traditional 401(k) plans, SIMPLE 401(k) plans, and safe harbor 401(k) plans. Each plan has different requirements and regulations associated with it, and it is up to the discretion of the employer to determine which plan works best for their company and employees.
It is important to determine which type of 401(k) plan your employer utilizes in order to understand what the plan consists of. To learn more about a few of the different types, read the following sections:
Traditional 401(k) plans allow eligible employees to make pre-tax contributions through deductions in their paychecks if they opt to do so. The traditional plan also allows employers to make pre-tax contributions to the plans of their employees either on behalf of all participants or by making matching contributions. It should be noted that withdrawals from a traditional plan will be taxed. Also, this type of plan is subject to specific nondiscrimination requirements. Those nondiscrimination requirements are put into place to ensure that the employer is contributing fairly to all employees.
Roth 401(k) plans are similar to the traditional plans, but they do differ mostly relating to the taxations of contributions and withdrawals. While a traditional 401(k) has your contributions go in before taxes are taken out, contributions to a Roth 401(k), occur after taxes are already taken out. The benefit for a Roth 401 (k) is that unlike a traditional plan, withdrawals are tax-free as long as the requirements are met.
Safe harbor 401(k) plans are very similar to the traditional 401(k) plan. However, the employer contributions are only viable when certain conditions are met. Being “fully vested” means that you cannot tap into those funds until you have worked at that company for a certain period or met a specific requirement established by the employer. The exact requirement for someone to be fully vested varies depending on the company and serves as a form of insurance for that employer. Also, it should be noted that the safe harbor plans are not subject to the same nondiscrimination requirements that are associated with the traditional 401(k) plans.
SIMPLE 401(k) plans were designed with the purpose being to provide retirement plan options for small businesses. The SIMPLE plan is more cost-effective and is not subject to the annual nondiscrimination requirements that typically apply to the traditional 401(k) plans. Similar to the safe harbor plan, the SIMPLE plan requires that employers’ contributions are fully vested.
You should understand that some 401(k) plans have an automatic enrollment feature that allows the employer to automatically take a percentage of an employee’s wages and place them into the 401(k) plan. This can be avoided, however, if you expressly choose to not have your wages reduced and contributed to the plan. Employers may choose to have a 401(k) plan with automatic enrollment in order to increase the participation in their plan, though you must know that you do have the option to opt out.
Also, it is important to understand what needs to happen with your 401(k) when you switch to a different employer. There are a few different options available including completing a rollover which transfers the funds from your old 401(k) to your new employer’s retirement plan, leaving the funds where they are, or cashing out the funds to use how you choose. Deciding what to do with your 401(k) money is a decision that must be made based on your personal financial situation.
There are restrictions often placed on 401(k) plans that are established by either the plan itself or by Internal Revenue Services (IRS) regulations. One of these restrictions is the amount of contributions an employee can provide through salary deferral contributions. A salary deferral contribution is when an employee reduces their salary by a percentage, and has that percentage instead go towards his or her 401(k). There are often caps placed on the 401(k) plan that limit the percentage of salary deferral contributions an employee can provide.
Also, restrictions may be placed on when you may withdraw money from the account. In most cases, penalties may apply if you withdraw money from your 401(k) account before you reach whatever the retirement age is for that particular plan. There may be exceptions, and this depends on the type of 401(k) plan you have and the reasoning you have for completing an early withdrawal. In some circumstances you can receive a hardship distribution from your retirement plan if you are experiencing a hardship that makes it necessary for you to withdraw funds.
In addition to having restrictions on taking money out of your 401(k) account, there are also certain limits that are placed on the amount of money that you may contribute. These contribution limits vary mostly due to your age. You should be made aware of the specific regulations for your plan before you opt to contribute any funds.
Also, understand that matching contributions can be made by the employer in certain plans. You should pay attention to the regulations on the contributions since there may be certain limits in place. For example, an employer may match your contributions dollar for dollar, or they may match less than 50 percent. Furthermore, the employer may only match up to a certain percentage of what you contribute. Additionally, the contributions matched by employers may be evaluated by annual nondiscrimination tests in order to ensure that the employer is contributing to each account as per regulation.