401k Definition

What is a 401k?

A 401k is an employer-sponsored, defined-contribution, and tax-favorable retirement plan. With this plan, employees can make tax-deferred contributions and enjoy a cost-effective retirement savings fund, while employers benefit from tax breaks.

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401k Explained

Everything about a 401K retirement savings plan is described in subsection 401(k) of the Internal Revenue Code. Hence, the plan is called “401K” or “401(k).” In the past, companies offered pensions as a standard benefit for employees. However, as years passed, the cost of running pension plans skyrocketed, prompting employers to seek new options. Nowadays, both employees and employers consider the 401K plan as a supplement to a pension fund.

Under the US tax code, a 401K is an employer-sponsored plan. It’s a company-wide benefit, and both employees and employers regularly contribute to the plan. The 401K is also referred to as a defined-contribution (DC) plan.

Employees give contributions to 401ks on a pre-tax basis. “Pre-tax” means contributions will flow directly from an employee’s paycheck into the plan before taxes are taken out, consequently lowering employees’ taxable income.

What’s more, these contributions are “tax-deferred.” In other words, all dividends and capital gains accumulated in a 401K account are exempt from tax until employees start withdrawing money from their accounts.

In addition to being a defined-contribution plan, a 401k plan enables employers to either match employees’ contributions or add a profit-sharing feature that allows the company to contribute from its profit. Either way, matched contributions represent easy, free money that can be added to retirement savings, making it by far the best perk of 401K for employees.

Employer Contribution Matching: Partial vs. 100%

An employer 401K contribution match takes place when an employer puts some money into an employee’s 401k accounts based on their total annual contribution. Employers will either partially or wholly match their contributions up to a certain portion of their total income.

Partial Matching

“Partial matching” is the most common type of employer’s 401K matching. A common scenario is for a business to match half of their employee’s contributions. Meaning, for every dollar invested by an employee in a 401K plan, the employer matches it with 50 cents.

If you’ve encountered matching written like “50% on the first 6%” or “3% on 6%,” that means employers match half of whatever their employees contribute, but only up to 3% of the employee’s total salary. To get the maximum benefits of the employer’s matching, employees should contribute 6% of their total salary.

Let’s say you earn $60,000 annually. Your employer will partially match your contribution with 3% on 6%. To maximize your benefit,  you contribute $3,600 (6% of $60,000) to your 401K account each year, and your employer will add $1,800 (3% of $60,000) annually to your account. That’s $1,800 worth of additional money each year.

Having said that, if you plan to put 8% or more so your employer will put more than 3%, that’s not going to happen. Employers will still only contribute 3% of your salary because that’s the maximum. However, if you can put in 8%, then go for it. Compounding interests can work on your 401k money, too.

Full Matching

“Full matching,” in contrast, means an employer contributes the same amount of money as an employee does, yet only still up to a certain amount. It’s also often referred to as “100% match” or “dollar-for-dollar matching.”

One common example of this is the matching “dollar-for-dollar up to 4%” of an employee’s salary. Putting it another way, if an employee puts in 4% of their salary, the employer will also have to put in 4%. However, just like in partial matching, if an employee puts in 6%, employers will only still put in 4% since that’s their max.

Using the same example as earlier, let’s say your employer offers full dollar-for-dollar matching, up to 3% of your annual income. Your employer will still contribute a maximum of $1,800 on your 401K account each year. To maximize the benefits, you also have to put in $1,800.

Contribution Limits

As stated by the IRS, all deferrals have annual contribution limits, regardless of whether the contributions are employees’ contributions or employer matching contributions. As of 2020, an employee’s contribution is limited to $19,500-$26,000 (for people over 50) each year. On the other hand, the combined employee and employer contributions are limited to 100% of compensation, or $57,000-$63,500 (for people over 50), whichever is less or comes first.

Can An Early Withdrawal Be Made to Pay Off Debts?

Apart from a personal online loan, a personal 401K saving plan is one of the go-to financing options you can rely on in an emergency situation. It can be utilized for home repairs, house purchase, education fees, medical expenses, home eviction or foreclosure moratorium, debt repayments, or any emergencies, including when an employee is being laid off.

However, employees with 401K plans can only cash out their elective-deferral contributions. To put it simply, they can only withdraw the money they had contributed to their 401K plan, and can’t cash out the deposits of their employers. It’s because an employer’s contribution is not eligible for debt repayment distribution, according to the IRS.

Additionally, the 401K plan is made to be primed for growth. If employees withdraw their 401K savings earlier, especially before their retirement age (59 ½ years), their contribution will be subject to a 10% penalty plus ordinary income tax.

For instance, an employee named Anna withdrew her 401K’s elective-deferral contribution early to pay off her daughter’s loan worth $28,400. Expectedly, she will have to pay a $2,840 early withdrawal penalty plus a federal income tax on this cashout.

Nonetheless, there are some situations when paying an early withdrawal penalty is more worthwhile than paying credit card debt interest in a year.

For example, you’re considering cashing out $28,400 from your 401K to pay off outstanding credit card balance with a high-interest rate. In this scenario, paying extra taxes is better than suffering from an increasing interest rate. The key is to thoroughly calculate tax penalties and interest costs before cashing out from your 401K savings.

About the Author: Karla Lopez is an aspiring financial advisor and a content marketer. Her written works mainly revolve in real-estate financing, various forms of lending, investment banking, insurance, asset management, and IoT applications on the financial sector.

Reviewed by Brandon Renfro, Ph.D.

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