Understanding Your 401(k) and Its Benefits

Chances are high that you’ve not only heard of 401(k)s, but actually own one of these wildly popular employer-sponsored retirement plans. More than 50 million workers actively participate in 401(k) plans, with over half-a-million different company plans in place. Overall in the U.S., a dizzying total of $4.5 trillion in assets is held within 401(k)s.

Yet participating in one of these plans doesn't guarantee that you grasp its complexities. The better you understand your 401(k), the better you'll appreciate how it fits within your investment portfolio and the more knowledgeably you'll be able to make adjustments to it over time.

Named after a section of the Internal Revenue Code, 401(k)s are defined contribution plans that employers sponsor as a retirement investment vehicle. If your employer offers a 401(k), you can opt, voluntarily, to contribute a percentage of your income to the plan. The contributions are automatically deducted from your paycheck, and as pre-tax income.

The average 401(k) plan offers numerous investment options, and many include additional features such as automatic enrollment and low-cost index fund options.

The IRS limits the amount you can invest in a 401(k). In 2019, the 401(k) contribution limit is $19,000, up from $18,500 in 2018. However, people 50 or older who expect to hit this 401(k) elective deferral limit can contribute an additional sum of up to $6,000 for a total of $25,000. This additional top-up payment is known as the catch-up contribution limit.

If you're prepared to top up your 401(k) with after-tax dollars, or your employer also contributes (more on that later), the limits are even higher: a total of $56,000 in 2019, up from $55,000 in 2018. If you are age 50 or older, your limit in 2019 is $62,000, including the catch-up contribution, up from $61,000 in 2018.

Looking ahead, 401(k) contribution limits are indexed to inflation, which means contribution limits will rise more in coming years, in step with inflation.

Withdrawals from your 401(k) are taxed at your prevailing income-tax rate at the time the money is taken out. There are restrictions on how and when you can withdraw money from the account. At age 70½, you must take what are called required minimum distributions (RMDs) from the plan, or else face tax penalties. If you withdraw funds from a 401(k) before you reach retirement age, you’ll be hit with a 10% early-withdrawal penalty fee as well as any applicable taxes. 

Note, however, that if you are still working at age 70½, you do not have to take RMDs from the plan at your current employer (see below for details). You will, however, owe them from previous 401(k)s, if you still have money in plans at any previous employers.

From favorable tax treatment to help from your employer to providing a shield from creditors, here's why it's a good idea to own a 401(k).

Tax Benefits

The tax advantages of a 401(k) begin with the fact that regular contributions are on a pretax basis. Because of that, the amounts you add to your plan up to that $19,000/$25,000 limit are exempt from current federal income tax, which means they lower your taxable income for the year in which you make them. To compound the benefit, literally, your 401(k) earnings accrue on a tax-deferred basis. That means the dividends and capital gains that accumulate inside your 401(k) are also not subject to tax until you begin withdrawals.

Since you won't, one hopes, start withdrawing funds until after you retire, chances are you’ll be paying less in tax than you did when you made the contributions. Most people earn a smaller income after retirement than when they were working, which places them in a lower tax bracket.

Matching Contributions

Some employers offer to match the amount you contribute to your 401(k) plan, and some even add a profit-sharing feature that contributes a portion of the company's profits to the pot as well. If your company offers one or both of these features, sign on for them; they essentially represent free money.

Here's how those employer perks can work. Many companies offer 50% of up to the first 6% you contribute to a 401(k). Let’s say you earn a $45,000 salary. If you contribute 6% of your annual earnings ($2,700) to your 401(k), your employer would contribute an additional 50% of that amount. That’s $1,350 of easy money. Some employers even go one better and match your contributions dollar-for-dollar for up the first 6%, which would add another $2,700 in this scenario, thus doubling your annual contributions to the plan.

Finally, remember the contribution limit of $19,000 a year? That applies only to what you put into the 401(k) personally; employer contributions do not count toward that annual contribution limit.

Continued Contributions If You're Still Working

With some retirement accounts, including traditional IRAs, you're no longer permitted to contribute once you turn 70½, even if you’re still working. That means money you might have contributed to such plans on a pre-tax basis is instead taxed at your current rate, which is likely to be higher than the rate you'll be paying after you retire.

401(k)s allow you to avoid these drawbacks. You can continue contributions to these for as long you're still working. Even better, while you're working you're spared from taking mandatory distributions from the plan provided you own less than 5% of the business that employs you.

Shelter From Creditors

If you run into financial trouble, it's helpful to have your money in places that creditors cannot access it. As it happens, 401(k)s offer excellent creditor protection. That’s because these plans are set up under the Employee Retirement Income Security Act (ERISA), and ERISA accounts are generally protected from judgment creditors.

Additionally, 401(k)s often offer some protection from federal tax liens, which are government claims against the assets of a taxpayer with unpaid back taxes. The fact that 401(k) plans legally belong to your employer, rather than you, makes it difficult for the IRS to place a lien on the account. Depending on the language contained in the fine print of your account, your plan administrators may be able to refuse outright to comply with an IRS lien.

The advantages of contributing pre-tax income to a regular 401(k) when your earnings (and tax rate) are at their peak may diminish as your career is winding down. Indeed, your earnings and tax rate may actually rise in future, as Social Security payments and the like begin to kick in.

Enter a different flavor of retirement account, the Roth 401(k), an option offered by an ever-increasing number of companies. Like its sibling, the Roth IRA, this account receives your contributions as after-tax dollars, but withdrawals are then fully tax-free as long as certain conditions are met. As with regular 401(k)s, the money in your account grows tax-free. However, as with regular 401(k) contributions, those to your Roth 401(k) are limited to $19,000 for 2019, although those aged 50 or older can similarly make an additional $6,000 catch-up contribution.

Roth 410(k)s are also an ideal avenue for high earners who want to invest in a Roth but may have their contributions to a Roth IRA limited by their income.

There are no income limits on being able to contribute to a Roth 401(k). By contrast, you can't contribute to a Roth IRA in 2019 if your modified adjusted gross income (MAGI) is $137,000 or more, and the allowed contributions start to phase out at $122,000. If you are married and filing jointly, reductions start at a MAGI $203,000 in 2019, with the phase-out starting at $193,000.

It’s little wonder that the 401(k) is the most popular employer-sponsored retirement plan in the nation. Offering numerous benefits, a 401(k) should be part of your retirement financial portfolio, especially if your employer matches any or all of your contributions.

Once you're aboard with a 401(k), however, don't simply sit back and allow it to run on auto-pilot. Changes from year to year in contribution limits. tax advantages, and your financial needs make it prudent to regularly review your plan's performance and any alternatives that may suit you better. One area to consider (but only after contributing enough to get the employer match, if you have one): Would you have more freedom to manage your retirement funds if you next max out your annual IRA contribution. For 2019, that is $6,000, with the option of going to $7,000 when you're 50 or older.