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401(k): What You Need to Know

May 25, 2022

401(k): What You Need to Know

Since its introduction in 1978, the 401(k) has been the go-to retirement plan for most employed Americans. Similarly, as an employer-sponsored retirement benefit plan, employers have since included it in their job perks to attract better employees. Its flexibility and host of tax unique tax benefits have also made it one of the best retirement benefit plans in the US.

Understanding the 401(k)

A 401(k) is a retirement savings account. Ideally, it's a long-term investment vehicle where employees divert part of their income to have something to live on in retirement. Typically, an employer may match an employee's contribution, albeit to a specific limit.

As a qualified retirement plan, the 401(k) enjoys certain unique tax benefits outlined in IRS guidelines. The 401(k) is known as a defined contribution plan in pension planning. In other words, the account's balance is a sum of the contributions made by the contributors and revenue generated from investments by the funds' manager.

Traditional 401(k) contributions are deducted from an employee's gross salary, and whatever growth takes place in the account grows on a tax deferred basis. However, any retirement benefits withdrawals from this retirement account are taxable when taken as income. While an employee has to contribute an agreed percentage of their salary if they sign up for a 401(k), the employer can match the employee's contribution partially, fully, or not.

Can I Pay Taxes Before Contributing to My 401(k)?

Yes and no. There are two types of 401(k) accounts - traditional and Roth 401(k). The conventional account is where contributions are deducted from pretax salary, thus counting as tax deductions for the tax year. This also means an employee's taxable income is much lower. Even if you want to, it's impossible to pay tax before contributing to a traditional 401(k). However, you'll pay tax on your withdrawals from the account.

On the other hand, contributions for a Roth 401(k) are deducted from after-tax earnings. Consequently, these accounts also grow on a tax deferred basis, but unlike the traditional 401(k) income, ROTH 401(k) income is not taxable. Unfortunately, not all employers offer this option.

So, which one is best for you? A traditional 401(k) is a better bet if there's a chance that by the time you retire, you'll have a lower income than today (lower income means paying less taxes). However, if you're sure your income will continue growing as you age, a Roth 401(k) may be a better option. This is something our firm can discuss with you.

Can I Withdraw from a 401(k) Before Retirement?

Yes. You can withdraw money from your 401(k) for whatever reason, albeit with hefty penalties if you do it before retirement. Generally, the only way to withdraw without penalties is if you're 59½ or older for traditional 401(k). To withdraw from a Roth IRA, you must have held and contributed to the account for at least 5 years and be 59½ or older.

If you take money from the traditional account early, the IRS considers it income and slaps you with an extra 10% tax bill on top of whatever your ordinary income tax is on the withdrawal.

If you withdraw from a Roth IRA early, the tax burden will be lower but significant. Because Roth 401(k) contributions are post-tax, early withdrawals don't attract income tax on the principal amount contributed. However, the IRS considers any interest earned by the contributions as regular income subject to ordinary income tax and the extra 10% penalty.

So, while it's possible to withdraw, the losses you stand to make far outweigh most benefits of withdrawing.

Can I Take a Loan Using my 401(k)?

If you must withdraw from your 401(k), the most affordable way is through a loan. However, some plans don't allow loans, so it's essential to confirm with your employer. Typically, your employer determines how much you can borrow from a 401(k), but it's often limited to 50% of your account value or a specific maximum dollar amount. Our firm can do an in-depth review of your plan to see if this option is available for you.

Provided you meet the stipulated criteria, getting a loan from your retirement account is better than an early withdrawal. Still, what you lose in potential dividends from invested funds is way more than you'll repay to your account as interest at the end of the loan.

A 401(k) is essential if you want a comfortable retirement. Still, many people don't understand how to make the most out of these accounts. Fortunately, our firm understands these retirement vehicles and can do a comprehensive 401(k) plan review to secure your future. Reach out to us to schedule a call to review your plan