A Guide to Defined Contribution Plans: How Does a 401(k) Work?

Workers looking to save for retirement may be offered the chance to use 401(k) defined contribution plans by their employers. What are 401(k)s, how do they work and what tax benefits do they offer?

What are 401(k)s?

A 401(k) is a type of defined contribution pension savings plan that allows workers to make payments from their earnings to create an income for retirement. Plans are most often offered by employers although they can also be set up by the self-employed.

There are two primary types of 401(k) plans. The first, often referred to as the traditional 401(k), gives tax benefits at the contribution stage (i.e. when payments are made). The second, the Roth, delays tax benefits until withdrawals start to be made in retirement.

How do 401(k) Defined Contribution Plans Work?

Defined contribution plans allow the individual to save a percentage of their salary up to certain annual limits via automatic payroll deduction. This money is invested into a 401(k) account. This usually comes with a variety of investment options (i.e. mutual funds or money market funds) and the individual may, therefore, need to choose how their money is invested for themselves.

Many employers will also add matching contributions to the money that their employees save. This can be a useful way of building extra retirement funds. The amounts contributed may vary and may come with certain limits and conditions. An employer, for example, may pay a certain amount per employee dollar up to a pre-set percentage of their salary.

When Can the Money in a 401(k) be Accessed?

The standard age to start to access funds invested in 401(k)s is 59½ and withdrawals generally need to start before the age of 70½ (unless the individual is still working). Making early withdrawals comes with an additional 10% IRS penalty. There are, however, some ways to release funds early without paying penalties such as hardship withdrawals. It may also be possible to borrow against a plan in some cases.

The Tax Benefits of Traditional & Roth 401(k)s

Some employers offer the chance to save into a Roth 401(k) as well as a traditional plan. Both options give the individual specific tax benefits at different times during the investment and withdrawal process. How do 401(k) taxes work and what are the advantages and disadvantages of investing in traditional 401(k)s and/or Roth alternatives?

401(k) Taxes, Pre-tax and Post-Tax Dollars

Those saving into a traditional 401(k) plan will have their contributions taken out of payroll on a pre-tax basis. This effectively means that they are able to put savings into their plans without being taxed on their payments. Here, tax liability is deferred until withdrawals are made.

A Roth 401(k), on the other hand, switches the payment of taxes to the beginning of the process rather than the end. So, any contributions made to a Roth plan will be taxed when they are made rather than when withdrawals start.

The Tax Benefits of Traditional 401(k)s

Many people prefer to use traditional plans because of the “front-loaded” breaks. Contributions made with pre-tax dollars will allow an individual to invest on a tax deferred basis. This may see more money invested into an account over the years before IRS payments need to be made. It may also see general taxable income reduced for the individual as payments are taken before deductions.

The Tax Benefits of Roth 401(k)s

A Roth 401(k) works differently. Here, the individual will have to pay tax on contributions as they are made. The benefits given will not be seen until the investment reaches retirement stage. So, for example, when withdrawals are made from a Roth plan, they will not be taxed as liability was covered during the payment stage.

The Tax Disadvantages of Traditional and Roth 401(k)s

Each type of 401(k) has its own merits and the choice of plan may well come down to individual preference and circumstance. Some, for example, prefer a traditional product as this saves money up-front. This will, however, shift tax liability into retirement age when money may be tighter than expected.

Some prefer to deal with their taxes up front and will save into a Roth 401(k) to benefit from the subsequent tax breaks during retirement. This may, however, cost individuals more during their working lives.

Traditional or Roth 401(k)?

Those given a choice of 401(k) plans by their employer can actually invest in both types if they wish. Some will use both investments and create two separate income streams for retirement, one that will be taxed and one that won’t.

It is worth keeping in mind that the income limits set on these investments will not, however, double up if the individual chooses to use both plans. The limit for any given year applies to any/all 401(k) investments. Employer matched contributions also cannot be invested in Roths and those will default to a traditional product.

Although each individual will have their own circumstances to consider, some will look ahead to use 401(k) taxes to help them plan where to save. For example, those that anticipate low tax liabilities in retirement may find a traditional option more cost-effective; those that will have to pay more may benefit from a Roth investment.

How Does Borrowing From 401(k) Plans Work?

Although the aim of 401(k) plans is to build income for retirement, some people find another use for their savings by taking out loans against them. If a plan allows borrowing, this may seem a relatively easy way to access a quick loan during your working life. What are the 401(k) loan rules and how does borrowing from a plan work?

401(k) Loan Rules, Tax and Borrowing Limits

A loan from a 401(k) plan is not subject to tax if it meets criteria set by the IRS. You can borrow up to 50% of the vested balance up to a maximum limit of $50,000. Borrowing must be paid off within 5 years, although this period may be extended if the money is used to buy a main residence for the first time. Repayments have to be made at least once a quarter and must be made in more or less level amounts.

Do All 401(k) Plans Allow Loans?

Although all 401(k) plans can allow loans, not all of them do. The rules set on borrowing may also vary from plan to plan which could see additional criteria added to standard IRS guidelines. So, for example, one employer may offer loans for any purpose; another may rule that loans can only be used for specific purposes (i.e. for medical costs, college expenses or to buy a first home). Those considering 401(k) loans should, therefore, check if they are offered by plans and if there are any additional specifications to consider.

How Does Borrowing From a 401(k) Plan Work?

Each plan will outline the application process for a loan. This may involve completing a form or applying by phone. It does not involve a credit check. Loans from 401(k)s must be repaid with interest as outlined by the plan. Repayments can be deducted from paychecks or paid from bank accounts but will not be made with pre-tax dollars as with plan contributions. If you don’t pay off your borrowing to schedule, then the borrowing may be viewed as an early withdrawal, at which point you may be liable to income tax and a 10% penalty. If you change job or are laid off, the loan may become due more quickly.

Are 401(k) Loans a Good Idea?

There are advantages and disadvantages to borrowing against a 401(k) plan and it may be wise to think hard about the pros and cons before applying for a loan. Although this can seem to be an easy and cost-effective way to borrow, it may have an impact on retirement income in the future. In some cases, if loans are not an option, then a hardship withdrawal may also be worth considering.

401(k) Withdrawal Rules: Taking Hardship Distributions From Plans

There may be times when it would be useful to take an early withdrawal from a 401(k) plan. Not waiting until the designated age of 59½ may add a penalty charge to regular income tax liability. Some 401(k) withdrawal rules, however, allow for hardship distributions. When can a plan holder withdraw cash from a retirement plan on a hardship basis?

401(k) Withdrawal Rules and Early Withdrawal Charges

Generally, 401(k) retirement funds are meant to be withdrawn from the age of 59½. Any withdrawals made from this age onwards will be liable to standard income tax charges. If, however, you plan on making an early withdrawal (i.e. before the age of 59½), then you may also have to pay a IRS penalty tax charge of 10%. This penalty may not be applied in the case of hardship distributions.

What are 401(k) Hardship Withdrawals?

There are certain times when the IRS will waive the 10% early withdrawal penalty for 401(k)s. These are known as hardship withdrawals or distributions. The options available may vary, but typically include:

  • The purchase of a first home.
  • Higher education/college costs.
  • Some medical expenses.
  • Payments to avoid eviction or foreclosure.
  • Burial or funeral costs.
  • Expenses needed for repair/damage to a home.

An Employee May Be Required to Provide Proof of Financial Hardship to Gain Access to 401k Funds

Whether or not an employee must prove a financial hardship to be eligible for an early withdrawal based on those criteria depends on the guidelines of the 401k plan. Typically an individual has two options to gain access to his or her 401k funds due to financial difficulties:

  • Proof of Need- If a 401k plan requires an employee to prove his or her need for the funds, it will stipulate which documents are required prior to cashing out the plan. Individuals may then continue to contribute to their 401k retirement plans beginning the following pay period.
  • Self Certification- Under self-certification, an employee is not required to provide proof to obtain a hardship distribution. An individual opting for self-certification, however, is restricted from contributing to his or her 401k for a period of six months following the distribution of retirement funds.

Penalties for Financial Hardship Distributions

Employees opting to cash out a 401k plan early for any reason will be required to pay taxes on the full amount withdrawn. Depending on an individual’s tax bracket, this can amount to 35-45% of the amount cashed out. The IRS also requires that the amount withdrawn be reported as gross income.

An additional tax on early distribution of elective contributions to retirement funds may be levied against the amount withdrawn, depending on the type of 401k plan.

Do All 401(k) Plans Allow Hardship Distributions?

Not all 401(k) plans have to allow for hardship withdrawals, although many do. Those that do provide this option may not, however, all operate in the same way or set the same criteria. Some may offer all allowed circumstances; others may specify that hardship only applies in certain situations. It is important to check plan rules first, rather than assuming that all early withdrawals will be eligible.

Are 401(k) Loans a Good Alternative to Hardship Withdrawals?

If a hardship withdrawal is not possible, either because it is not available in a plan or because the individual is not eligible, then it may be possible to look at a 401(k) loan instead. The money borrowed will need to be repaid within a set period of time in order to avoid income taxes and the 10% penalty charge. This may be a viable solution for some. Others may prefer not to borrow against their retirement savings as this can affect overall returns over time.

Limitations on Hardship Distributions

Consumers hoping to cash out a 401k should be aware that, even if a hardship withdrawal is permissible under their retirement plan, there are still limits to how much can be withdrawn. The employee’s financial situation must meet certain criteria such as:

  • The funds contained in the 401k plan must be enough to meet the employee’s need
  • Funds in excess of the financial need may not be withdrawn under financial hardship.
  • The employee must be unable to meet his or her financial need any other way.
  • Funds in excess of what the employee contributed may not included in a hardship distribution

If an employer is aware of the fact that an employee attempting to have an early withdrawal approved is in possession of other assets that, when liquidated, would provide the necessary funds to meet the employee’s financial need, he or she may decline to cash out the 401k.

401k Rollover to IRA Guide

Given the popularity of 401k retirement plans and the frequency with which people change jobs, it is almost a given that just about everyone will at some point be faced with the prospect of accomplishing a 401k rollover to IRA. The 401k rollover process is not as complicated as some people might imagine. Like most things in life, it is simply a matter of understanding what needs to be done.

Those who have contributed to a 401k and change jobs generally have three choices; leave the 401k as is with the previous employer, cash out the plan and take a distribution or roll over the 401k to an IRA.

401k Rollover Options

For those whose individual financial circumstances make a 401k rollover to IRA the best choice, there are a number of options that must be considered. First, it must be decided whether a Roth IRA or traditional IRA is the best choice.

Since 2010, rolling over a 401k plan to a Roth IRA has been permitted. Choosing the Roth IRA option however triggers a taxable event as is explained in the most recent IRS Publication 575, “Pension and Annuity Income,” dated 08 Dec. 2009. Rolling over a 401k to a traditional IRA however does not produce a tax bill since it is simply a matter of moving assets from one tax deferred vehicle to another. No taxes become due until a person begins taking distributions from the IRA.

401k Investment Rollover Choices

After deciding on the type of IRA to be used, the next step is deciding where to put the retirement money. Nearly all financial institutions offer IRA products these days so consumers have a wide variety of choices on where to invest. There are advantages and disadvantages to each so before deciding where to open an IRA account, look at things like investment options available and fees.

As an example, discount brokerages are popular for 401k rollovers but investments incur brokerage fees. Choosing a mutual fund company eliminates the brokerage fees but many charge an annual IRA maintenance fee so as can be seen there are trade offs to be considered. One advantage to using a mutual fund company is that they have rollover specialists on staff to assist with rollovers which can be things even easier.

Once a financial institution has been chosen, the next step is opening an IRA account. Choosing the individual investments from those available comes later after the assets of a 401k plan have actually been transferred to the institution selected.

Getting the Funds Transferred from 401k Retirement Plans

A recent quarterly statement will usually provide contact information for the 401k plan. Those who don’t have a recent statement available can start by contacting a human resources representative at their former employer. When contacting a plan, let them know that you are planning a rollover to an IRA and:

  • ask if there are any fees involved for rollovers
  • request all necessary paperwork needed to affect a transfer of funds to the IRA custodian
  • inquire whether they require contact from the IRA custodian chosen or any paperwork from them to affect the transfer of funds.
  • Once the rollover paperwork has been received, complete it and then return it to the 401k plan. It can typically take several weeks for the actual transfer to be processed. Don’t neglect to follow up if the transfer has not be completed within 30 days.

Once notification has been received from the IRA custodian that the funds from the 401k have been transferred to the IRA account, individual investments can be selected. Depending upon the type of financial institution selected, again a rollover specialist may be available to explain investment options and to help in choosing the right types of investments to meet specific investment goals.

In summary, initiating a 401k rollover to IRA need not be intimidating or difficult and rollovers to an IRA can have real advantages; a wider selection of investment products to choose from, the possibility of lower fees than those charged by many 401k plans and greater personal control over retirement assets.

401(k) Calculators: Calculate Contributions, Loan Costs & RMDs

401(k) calculators can be useful tools in the retirement planning process. Some will use a calculator to assess whether it is worth saving into a company or solo plan. Those with existing plans can also assess how contribution changes may affect overall income. Some versions may also be useful for those considering taking loans from 401(k)s or those that need to know their required minimum distributions towards the end of the savings process.

Using 401(k) Calculators to Estimate Retirement Savings

Those considering saving into a plan may find it useful to use an online calculator to assess potential savings returns. This may also be a useful exercise for people with existing plans who are considering changing their percentage contributions in some way.

At a basic level 401(k) calculators will take the data inputted by the individual and use it to calculate projected income in retirement. More sophisticated tools will allow the user to look at different scenarios by manipulating data on the screen. So, for example, a calculator may show how increasing or decreasing contributions might change later income potential.

Using a 401(k) Loan Calculator to Assess Borrowing Costs

Some calculators can help estimate the costs of taking loans on 401(k) plans. If allowed, this can be a relatively simple way to borrow money. It may, however, come with some major disadvantages and checking the actual costs of a loan and assessing how this will affect retirement income may be worth doing.

A 401(k) loan calculator may help some to work out whether this is the best borrowing solution. These tools can take the details of a plan and the projected loan and help the individual to see how much they may ultimately pay. This isn’t just a question of the costs of repaying what was borrowed – it may also have a negative effect on overall retirement savings so this may be useful to know.

Using a Required Minimum Distribution Calculator

The rules governing 401(k)s generally dictate that the owner of a plan must start to make withdrawals by the time they reach the age of 70½. These compulsory withdrawals are called required minimum distributions (RMDs). The amount that must be taken out of a plan each year is based on dividing its value by a life expectancy factor. RMDs are set by the IRS.

An RMD calculator can help individuals get their own projections of withdrawals without having to make their own calculations. So, for example, a program simply needs to know the value of the plan and the age of the individual. It will then work out the withdrawal factor based on IRS tables and show the projected withdrawal amount.

Some calculators may give useful additional information. It is, for example, also possible to learn the rate of return that will be needed to keep the balance of the 401(k) at the same level after the withdrawal has been made.

It is worth remembering that not all 401(k) calculators are equal and that they are best used as a source of ballpark information. It is also important to use programs from reputable companies/websites.