By Amie Agamata, CFP
Most people are familiar with a 401(k) plan to some extent. Investopedia defines a 401(k) plan as “a retirement savings plan offered by many American employers that has tax advantages to the saver.” In other words, a 401(k) plan is set up by employers to help employees save for their retirement.
We all know that saving for retirement is important. However, according to the Bureau of Labor Statistics’ National Compensation Survey for 2019, only 43% of workers participated in a retirement savings plan. No one ever regrets starting to save too early, so why are less than half of the workforce contributing to their 401(k) plans? There’s no definite answer, but perhaps if more people understood the opportunities available through their 401(k) plan then they would be more inclined to start saving.
Here are 4 things you should know about your 401(k) plan:
- There’s potentially free money on the table – Many employers set up the company 401(k) plan with a matching program to encourage employees to save. For example, some plans include a “safe harbor match” where the employer matches 100% on the first 3% and 50% on the next 2%. This means the employee must save at least 5% of their paycheck to receive the full employer match (4%). The below table demonstrates how much the employee receives based on a safe harbor match.
It’s important to understand how your employer may be contributing to your retirement plan because you may be leaving free money on the table if you’re not saving what’s required to receive the full match. The Summary Plan Description (SPD) will tell you how your employer contributions are made. Your human resource contact should be able to provide you with a copy of the SPD if you can’t find it online via your 401(k) website.
- Roth contributions up to $19,500 ($26,000 if over age 50) regardless of income. Many people think they make too much money to contribute to a Roth, so they either consider backdoor IRA strategies or end up saving on a pre-tax basis only. It is true that you can’t contribute to a Roth IRA if you make over $140,000 ($208,000 married filing jointly) in 2021, however, that rule does not apply for Roth 401(k) plans. There is no income limit for Roth 401(k) plans. That means anyone, regardless of their income, can save $19,500 (plus $6,500 catch up if over 50 years old) on a pre-tax or Roth basis as long as their company’s 401(k) plan includes the Roth feature. Most 401(k) plans allow Roth contributions, but there are some plans that have not adopted it at this time.
Roth contributions are made with after-tax dollars, so your account grows tax-free and Roth distributions in retirement are generally not subject to income taxes. On the other hand, withdrawals from a traditional pre-tax retirement account are considered taxable income. Tax diversification is important from a planning perspective especially when you reach the decumulation phase of your portfolio.
- 401(k) plans generally have better creditor protection than other retirement savings accounts. If you’re like most Americans and have some level of debt, it’s important to understand which accounts are protected from creditors before taking a distribution if you’re in a financial pinch.
While it may be tempting to make an early withdrawal from your 401(k) plan, the money you save up in your company’s retirement plan is generally protected from creditors, bankruptcy proceedings, and court judgments because these plans are set up under the Employee Retirement Income Security Act (ERISA).
Individual retirement accounts (IRAs) are protected against bankruptcy up to a certain amount, however, they’re not ERISA-qualified so they don’t have the same level of protection as your 401(k) plan. If you have an IRA, you may want to consider rolling it into your 401(k) plan for better creditor protection if your plan allows rollover contributions. Roth IRAs are not allowed to be rolled into Roth 401(k) plans under current regulation.
- You may be able to access your retirement savings before you actually retire. Unlike IRAs, 401(k) plans are often set up with loan provisions, meaning you can borrow from your retirement savings then pay yourself back with interest, typically within five years.
Plans generally allow loans up to 50% of your vested balance or $50,000, whichever is less. You don’t have to pay any penalty fees or taxes when you take out a loan, however, if you leave your current company then you will have to pay off the remaining balance within a short period of time or recognize taxes and early withdrawal penalties if you’re under age 59 ½.
Another way to access your savings may be through a hardship distribution. A hardship distribution allows you to take money out of your plan without paying any penalty fees if you’re experiencing an immediate and heavy financial need. The amount of the withdrawal is taxable and limited to the amount of the hardship, i.e., medical care expense, tuition, etc. And, you must submit supporting documentation to your employer that proves you’re truly experiencing a hardship.
The third way to access your money before you retire is through in-service distributions at age 59 ½. Sometimes employees may consider rolling over all or part of their assets as they mature because they want more investment options outside of their 401(k) plan. Check your plan’s Summary Plan Description to see if your company allows loans, hardship, and in-service distributions.
If your employer doesn’t currently offer a 401(k) plan, there are other ways to save for your retirement like setting up an IRA and/or Roth IRA where you contribute up to $6,000 per year ($7,000 if over the age of 50) between the two accounts. If you work for yourself, you can create your own retirement plan and potentially receive significant tax deductions if the plan is set up correctly. It’s best to work with a retirement plan specialist to help you determine what may be in your best interest.
About the author: Amie Agamata, CFP®
Amie Agamata is a CERTIFIED FINANCIAL PLANNER™ in San Diego, CA with clients across the U.S. Her team’s business mission is “working together to achieve financial success through understanding, education, and action©.” Amie serves as the NexGen president for the Financial Planning Association (FPA) of San Diego and member of the FPA Retirement Income Planning Advisory Council.
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