By Ryan Graves on Dec 12, 2019

Categories Education, 401(k), Retirement

A 401k plan is an employer-sponsored, defined-contribution plan that provides savings and tax benefits to workers.  Its name comes from its section in the U.S. Internal Revenue Code.  Workers have money automatically deducted from their paycheck and deposited into the account on their behalf.  The contributions and investment earnings are not taxed until the employee withdraws that money, typically in retirement.  Roth 401(k) plans, in contrast, are taxed upon contribution, and the withdrawals are tax-free. 

A 401(k) is known as a defined-contribution plan.  The employee and employer can make contributions to the account, up to the amounts allowed by the IRS ($19,500 for 2020).  Pensions are known as defined-benefit plans.  Under a defined-benefit plan, the employer is responsible for providing a specific amount of money upon retirement.  401k plans put a lot more responsibility on the worker to save and invest than what pension plans do, and as a result, have become much more prevalent in recent decades.  

Employees are responsible for choosing the specific investments, from a line-up offered in the plan, and level of risk they are willing to take within their 401k. The offerings typically include mutual funds, target-date funds and may consist of the employer’s stock.  

Employer Matching

Employers may choose to match their employees’ contributions.  The formulas that employers use to figure out the contributions range. They can match dollar per dollar to a certain amount or using a fixed percentage to a designated max percentage.  It is essential to save up to the maximum match, as that is “free money” that the employee receives in the plan.  

If your employer offers both traditional and Roth options, you may contribute to both accounts.  However, it is essential to note that you are still limited to the maximum amount of $19,500 for both accounts.   

Withdrawals 

Once your money is is in your 401)k) plan, it is difficult to access without penalty.  So, it is crucial to build up savings in addition to your 401(k) for emergency purposes. 

The earnings in a traditional 401(k) plan are tax-deferred and tax-free in Roth accounts.  When making withdrawals from a tax-deferred account, that money will be taxed as ordinary income.  Roth account withdrawals will not owe taxes on withdrawals so long as they meet these requirements:

  1. The withdrawal happens at least five years after the account is funded
  2. And one of the following:
  • The account holder is at least 59 ½ at the time of the withdrawal
  • An amount of no more than $10,000 is withdrawn  to purchase or rebuild a first time home for the account owner or qualified family member
  • The owner of the account becomes disabled
  • The assets are distributed to the beneficiary of the account after the account holder’s death.

    
With a traditional IRA, the owner must be 59 ½, or meet other criteria, when making the withdrawals.  After age 70 ½, the account owner must begin withdrawing a certain percentage of the account from their 401(k) plan(s).  The amount is determined by IRS tables and their given life expectancy at that time. Roth IRAs are not subject to RMDs during the owner’s lifetime as that money has already been taxed.  

Which One is Better, Roth or Traditional?

It really all depends on if you expect your tax rate in retirement to be higher or lower.  If you expect your tax rate in retirement to be smaller, it makes sense to use a traditional account, if it is tax-deferred. If you expect taxes to be higher, it makes sense to go for the Roth.  Generally speaking, younger workers earning lower wages are in lower tax brackets, so it makes sense to use  Roth account.  As their salaries increase and they get into a higher tax bracket, the tax-deferred account makes more sense.  As the future is always uncertain, it makes sense to hedge your bets and use both accounts.  Regardless of an individual’s earnings, tax rates can change through legislation, so the tax rate in retirement is genuinely unknown.

 

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