Most people with any time in the workforce have a 401(k). It’s one of the most common benefits offered by employers today.
Although 401(k)s are typically included in financial planning conversations, it’s important to understand the ins and outs of how a 401(k) plan works. If you think this information may be helpful for anyone you know, please feel free to share.
What is a 401(k) Plan?
A 401(k) plan is a defined-contribution, tax-advantaged retirement savings plan, usually set up by your employer.
There are two main types of 401(k) plan options: traditional 401(k) plans and Roth 401(k) plans.
Traditional 401(k) Plans
Using a traditional 401(k), your contributions are deducted from your gross income. This means your tax-deductible contributions are taken out of your paycheck before taxes. There are no taxes deducted from your contributions or to the investment earnings you make from that account until you withdraw the money.
Roth 401(k) Plans
Using a Roth 401(k), your contributions are deducted from your after-tax income, so there are no tax deductions for your contributions that year. When you withdraw the money, either when you leave the company or retire, no additional taxes are due on your contributions, provided you meet certain criteria.
Contributing to Your 401(k)
A 401(k) is a defined contribution plan which means that you and your employer can make account contributions up to a defined dollar amount that the IRS sets. This contribution limit changes from year-to-year to account for inflation. As of 2023, the annual employee contribution limit is $22,500 per year for people under 50, or for people 50 and older the contribution limit is $30,000 per year. If your employer also contributes to your 401(k), the total employee-employer contribution limit can’t exceed $66,000 for people younger than 50 or $73,500 for people 50 and older.
Earning Potential on Your 401(k) Contributions
Beyond what you and your employer contribute to this investment account every year, you can earn a rate of return on these contributions/investments. The more time your contributions must sit in your 401(k) account, the more earning potential they may have.
Withdrawing from Your 401(k)
The type of 401(k) you have – traditional or Roth – can influence your taxes when it comes time to withdraw the funds from your account. Regardless of the type of 401(k) account you have, you must be at least 59.5 years old (or meet other criteria) to begin making withdrawals; otherwise, you’ll face an early penalty tax on top of any taxes you owe.
As we continue to review your financial strategy together, we’ll continue to reassess opportunities to maximize your retirement plan options. As always, contact the office if this has sparked any questions or additional topics you want to discuss.
Some IRA’s have contribution limitations and tax consequences for early withdrawals. For complete details, consult your tax advisor or attorney.
This material was developed and prepared by a third party for use by your Registered Representative. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security. The content is developed from sources believed to be providing accurate information.
Distributions from traditional IRA’s and employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59 ½, may be subject to an additional 10% IRS tax penalty.
Converting from a traditional IRA to a Roth IRA is a taxable event.
A Roth IRA offers tax free withdrawals on taxable contributions.
To qualify for the tax-free and penalty-free withdrawal or earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 ½ or due to death, disability, or a first-time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes.