Understanding 401(k) Retirement Plans
- Last Updated: Thursday, 02 April 2020
Anyone planning to retire one day needs to consider enrolling in their employer’s 401(k) plan. These plans are one of the premier ways to save money, thereby supplying individuals with a reliable source of retirement income.
Even employees that are relatively new to the workplace should consider participating in their employer’s 401(k) plan. Here’s a simple example that demonstrates why it’s so important to start today.
Let’s say that Emily just graduated from college, and she is planning to work until she’s age 62. That’s roughly 40 years in the workplace. At age 62, it’s reasonable to assume Emily will live until age 85. This gives her 40 years to save enough money to produce income that will last another 23 years in retirement.
If Emily waits until she’s in the middle of her career before she starts contributing to a retirement plan, she’ll need to set aside a lot more money to reach her savings targets. It’s a pay me now, or pay me later, situation.
We’ve put together a significant number of articles that cover several 401(k) topics. This includes withdrawals, loans, rollovers, rules, and contributions. We also provide a number of tools that can be used to run through some high-level retirement planning scenarios.
In the following sections, we’ll outline where detailed information can be found for each of these topics.
A 401(k) plan is meant to be used for retirement purposes. When experts talk about withdrawals, they’re usually talking about what are termed normal distributions. This is money removed from an account after the age of 59 1/2. There are also several categories of early withdrawal exceptions. Our article on 401(k) withdrawals outlines those circumstances that allow funds to be removed without penalty.
In fact, we have an article dedicated to a specific type of early distribution: a 401(k) hardship withdrawal. This article discusses both safe harbor withdrawals as well as borrowing money from a 401(k) plan.
The Internal Revenue Service allows 401(k) plan participants to borrow money from their savings accounts, in the form of a loan, and without any taxation penalties. But participants also need to be aware of the specific rules that apply to their company’s plan. Generally, 401(k) loans are allowed under most plans to pay for expenses such as college tuition, a home mortgage, medical expenses, and buying a home for the first time. But borrowing against an account might preclude an employee from participating in their employer’s plan until the loan is repaid. The plan administrator can help with plan-specific rules.
The days of lifetime employment are over, and moving from company-to-company is commonplace today. Most plans allow employees to continue to manage their 401(k) after they’ve left, but some companies may “freeze” a plan. That’s why it’s good to know about 401(k) rollovers and the rules to follow in order to avoid a tax penalty.
If a former employer can facilitate a direct rollover, this can help avoid potential problems. Individuals thinking about managing this process alone need to be aware there are some timing limits when a rollover payment to an individual occurs.
Most experts believe that 401(k)’s are the single most important retirement benefit an employer can offer employees – beyond a pension plan. To help with that decision, we have an article for employers thinking about offering a plan to their employees: 401(k) rules. The process of establishing a plan is fairly simple, and there are only four high-level requirements. Documenting the plan is important, as is incorporating flexibility.
We have two articles dedicated to the topic of 401(k) contribution limits. Both of these articles clearly explain the contribution rules and limits that apply to both employees and employers. They also discuss a special kind of contribution limit that affects employees age 50 and over: the 401(k) catch-up contribution.
Retirement Planning Tools
Individuals that like to perform back-of-the-envelope calculations should be interested in our article: investing for retirement. There we discuss retirement planning that goes beyond 401(k) plans, but more importantly we provide a retirement planning spreadsheet that can be downloaded for free.
Anyone that doesn’t think it’s important to start saving for retirement early in their career needs to work with that spreadsheet. It’s surprising how much of the financial burden is lifted by starting a plan early.
Individuals that would like to run through some more sophisticated planning scenarios can use one of the many retirement calculators we have to offer. These calculators can be used to figure out how much money is needed in retirement and / or how much money to save each year to provide a comfortable level of retirement income.
Retirement Plans in the Future
As the baby boomers enter their retirement years, there will be a larger proportion of Americans that depend on retirement plans for their income. For about 10 years we really didn’t see much progress in the contribution limits the government established for most qualified retirement plans.
Now individuals that reach age 50 and over in a calendar year can make catch-up contributions to their 401(k) plans and to their Roth IRAs. In fact, the growing popularity of the Roth IRA is now starting to extend its reach in the form of a Roth 401(k).
Starting back in January of 2006, many employees were faced with the option to start funding another type of retirement account – Roth 401(k) plans. This program borrows from the concept of the Roth IRA (after-tax contributions) in exchange for tax-free withdrawals at retirement.
About the Author – Understanding 401(k) Retirement Plans