401(k) Plans

What is a 401(k) Plan?

 A 401(k) plan is a self-directed, qualified retirement plan established by an employer to provide future retirement benefits for employees. Employee contributions are made on a pre-tax basis, and employers match a portion of the employee contributions.

If you have a Roth 401(k) option, your contributions are made with after-tax dollars and are tax-free when distributed. Earnings may also be tax-free under certain conditions.

If you elect to participate in a 401(k) plan, you can allocate a percentage of your salary to your plan every paycheck. The maximum annual contribution is $19,500 in 2021. If you will be age 50 or older before the end of the tax year, you may also contribute an additional $6,500. The funds in your pre-tax account will accumulate tax deferred until withdrawn, when they are taxed as ordinary income.

Some employer plans provide 100% immediate vesting for employer contributions.  Others may be subject to vesting schedules, which means you are only entitled to a portion of your employer’s contribution.  Your contributions are always 100% vested. The maximum length of a vesting schedule is six years of service.  An employee is legally entitled to all the contributions made by the employer, as well as earnings on those contributions, when fully vested.

Generally, you must begin taking required minimum distributions (RMDs) from 401(k) plans no later than April 1 of the year after you reach age 72.  Distributions from pre-tax 401(k) plans are taxed as ordinary income and may be subject to a 10% federal income tax penalty if withdrawn before age 59½, except in special circumstances such as disability or death, or separation from service after age 55.  Roth 401(k) balances are also subject to RMDs.  At termination of employment or retirement, plan balances may be eligible to rollover to an IRA and/or Roth IRA.

A 401(k) plan is a great way to save for retirement, especially if your employer offers matching contributions. If you are eligible to participate in a 401(k) plan, you should take advantage of the opportunity, even if you have to start by contributing a small percentage of your salary. This type of plan can form the foundation for a sound retirement funding strategy.