Retirement Plans Explained: The 401(k)
Updated: Dec 4, 2020
Our last blog post provided a glimpse into the two types of employer-sponsored retirement plans: defined benefit plans (pension plans) and defined contribution plans.
Although pension plans were very popular among employers of the past, most employers today offer defined contribution plans, which require the employer to shoulder less risk and responsibility. The most common type of defined contribution plan is the 401(k).
A 401(k) plan allows you to start saving right away by contributing a percentage of your pretax income to the plan each month. Some employers also offer profit-sharing through their 401(k) plans. Barring certain exceptions, distributions taken from a 401(k) are subject to a 10% federal penalty in addition to income tax if withdrawn before age 59 ½.
The typical 401(k) plan allows employees to choose from several investment options:
Shares of Company Stock
Mutual Funds are the most common investment option available in 401(k) plans. A mutual fund is a diversified portfolio of investments chosen and maintained by a fund manager. There are a few different types of mutual funds:
Bond Funds consist solely of bonds.
International & Global Stock Funds primarily invest in companies outside of the United States, offering global investment diversification.
Target-Date Funds choose investments based on the year in which an investor plans to retire. The earliest investments tend to primarily consist of stocks; as investors get closer to retirement age, the asset allocation of the fund changes to include more conservative investments.
Exchange-Traded Funds (ETFs) are similar to mutual funds, featuring an array of diverse investments. Unlike mutual funds, which are only traded once per day, ETFs are traded on an exchange just like stocks; shares are bought and sold throughout each trading day. There are several types of ETFs:
Bond ETFs can include government, corporate, and municipal bonds.
Industry ETFs track a particular industry.
Commodity ETFs include investments in commodities such as crude oil.
Currency ETFs are investments in foreign currencies.
Inverse ETFs seek to profit from stock declines by “shorting” stocks. Shorting a stock means selling it before an expected decline in its value, then repurchasing the stock at a lower price.
Guaranteed Investment Contracts (GICs) are conservative, stable investments sold to investors by insurance companies. GICs guarantee a specific rate of return in exchange for investing your money for a specified period. These pay higher interest rates than most savings accounts, but the rates are still relatively low compared to those of other investment types. Frequently marketed to tax-exempt entities such as churches and non-profit organizations, GICs are less risky than mutual funds and offer a lower return on investment.
There are many benefits to having a 401(k) retirement plan:
Regular contributions (up to a specified limit) are exempt from federal income tax until you begin taking distributions, benefiting individuals who expect to be in a lower tax bracket upon entering retirement.
Employers have the option to match employees’ 401(k) contributions up to a certain percent. For example, an employer may choose to match 50% or even 100% of the first 6% of your contributions; this is essentially free money that you can start earning immediately upon enrolling in a 401(k).
Although annual individual contributions are limited to $19,000, employer contributions do not count toward this limit. Combined contributions are limited to $56,000 annually.
No Age Limit
There are no age limits on 401(k)s; you may continue to contribute to your 401(k) for as long as you are still working.
Additionally, employees who continue working for their plan sponsor past the age of 72 are not required to take Required Minimum Distributions (RMDs) from that 401(k). However, these workers are still required to take RMDs from any 401(k) plan under a previous employer.
401(k)s provide excellent creditor protection. Thanks to the Employee Retirement Income Security Act (ERISA), you won’t have to worry about losing your retirement funds even if you run into financial trouble.
Catch-up provisions allow eligible employees who are close to retirement to contribute more than the standard annual contribution limits. The 2019 standard catch-up rate for 401(k)s, 403(b)s, and some 457 plans allows participants age 50 and older to contribute an additional $6,000 per year.
Does your employer offer a 401(k)? If so, consider taking advantage of the opportunity by enrolling right away. You can start building financial security for your future self today.