In this post:
- Introduction: What is a 401(k)?
- Employer Match
- Self-employed 401(k)s
- Tax deferral vs Roth, what’s the difference?
- After-tax, non-Roth contributions… Why?
- Pitfalls and Risks of a 401(k)
- What’s an RMD and why should I care?
- Early retirement considerations
- What do I do with my old 401(k) from a previous employer?
This is a series that I posted to the Facebook group a while back. I’ve aggregated those posts and pasted them all below, to make them easier to find and review. The formatting isn’t great, because it’s just a copy/paste from the Facebook group. I’ll probably come back and clean it all up a bit, down the road, but for now…
The 401(k) 411 – Introduction
Do you have access to a 401(k)? Do you use it? Do you have any questions about how to get the most out of your 401(k)? I’m putting together a series of posts about 401(k)s and similar retirement plans like 403(b)s. Let me know if there’s anything you’d like to see covered!
What is a 401(k)? A 401(k) is a tax-advantaged, employer-sponsored retirement account named after the subsection of the Internal Revenue code that defines it. There are other very similar employer-provided retirement accounts such as the 403(b), which can be thought of as a special 401(k) for employees of public schools and nonprofits. There are a few differences between these various types of employer-provided retirement accounts, but for the purposes of this series of posts, we’re just going to use the term 401(k) as a catch-all.
Provided by employers – Not every employer will choose to provide a 401(k). Employers that do provide them can set eligibility criteria for their employees. Folks who are are self-employed and have no employees (other than a spouse) can choose to set up a solo401(k) in which they act as their own employer.
Tax-deferral – The portion of your income you choose to contribute to a 401(k) is not taxed at the time of contribution. This can provide a significant reduction to your tax bill in the year that you make the contribution. However, it is not tax-free. When you eventually withdraw funds from a 401(k) in retirement, those withdrawals are taxed at the regular income tax rates for the entire amount of the withdrawal, not just the gains.
Contribution limits – Federal law limits contributions to 401(k)s. In 2021, that limit is $19,500 for employees under 50 years of age. Those over 50 can contribute up to $26,000 per year.
Employer contributions – Employers may also contribute to these accounts on behalf of their employees, often in the form a matching contribution.
After-tax contributions – Some plans allow employees to contribute additional funds above the $19,500 limit. These contributions are called “after-tax” because they are paid with regular taxable income. In other words, you don’t get the initial tax deduction for these types of contributions.
Combined limits – The total combined yearly contribution limits, including employee contribution, employer contribution, and after-tax contributions, is currently $58,000, or 100% of your income if your total income is lower. For those 50 and over, the limit goes up to $64,500.
ROTH 401(k) – Some 401(k) plans allow for “Roth” contributions. This is an alternative option of tax savings that you may choose if you expect that your taxes in retirement will be higher than your current taxes. Instead of taking a tax deduction on this year’s contributions and then paying regular income tax on the withdrawals, a Roth 401(k) is funded with after-tax dollars, and future withdrawals in retirement are 100% tax-free.
Early withdrawal penalties – The 401(k) is set up to encourage saving for retirement. In order to prevent people from using it as a tax shelter for income they plan on using before retirement, there is a penalty charged for withdrawals taken before a defined retirement age. Currently that age is 59 and a half, and the penalty is an additional 10% on top of the regular income tax that you’ll have to pay.
Required minimum distributions – Because 401(k)s are intended as retirement savings vehicles and not as a means of generating a perpetual stream of tax-sheltered wealth for heirs, there are rules that require you to eventually withdraw (ie “distribute”) your funds. The current age at which this happens is 72, and the amount you have to withdraw comes from actuarial tables define by the IRS.
401(k) 411 – EMPLOYER MATCH
Tax deferral vs Roth Contributions
After-tax, non-Roth contributions
Pitfalls and risks
Early withdrawal penalty: If you need the money in your 401(k) before you reach “retirement age” (as defined by the IRS, currently 59.5) then you will pay a 10% penalty on the amount you withdraw. This is on top of the income taxes that you will also have to pay, and is 10% of the total amount, not just the investment gains. Let’s say you have a non-medical emergency that’s too big to cover with your emergency fund, and the only other savings you have is in your 401(k). So, you withdraw $10,000 from the 401(k). If you’re in the 22% tax bracket, you’ll pay $2,200 in taxes on that withdrawal. You’ll also pay another $1,000 in penalties. That leaves you with only $6,800 of your $10,000 withdrawal.
There are exceptions that allow you to withdraw funds from a 401(k) without penalty. These are:
Fees: Some 401(k) providers charge relatively high fees, or offer only high-fee mutual funds for you to invest in. Sometimes, these fees are high enough that your long-term net growth will barely be better than wise investing in a non-tax-advantaged account. You’ll have to run some numbers to see if your provider’s fees will be a problem for you, but in general, you want the fees to be less than 1%.
Fund selection: Many 401(k)s provide a very limited selection of funds for your investments. These funds may not provide access to the kinds of investments you’d prefer, or they may have high fees associated with them.
WHAT TO DO ABOUT IT?
If you’re math-savvy, you’ve probably noticed that this formula is designed so as to leave you with a zero balance in your 401(k) at the end of your life. This doesn’t mean you won’t have the money anymore–just that it will no longer be in the 401(k)… and you will have paid income taxes on the entire amount. If you pass before your 401(k) is empty and your beneficiary is someone other than your spouse, then–as of 2020–that person has 10 years to empty the account, paying income taxes on the amount as they go. Thus you cannot use a 401(k) or other tax-deferred retirement account as a way of avoiding or deferring taxes on the kind of wealth that would be passed down through many generations.
And remember, there’s no rule that says you have to spend those distributions. It might be a good idea to transfer your distributions to a regular taxable investment account, or at least a savings account, depending on how immediately you might need the funds.
Other exceptions happen from time to time, but are extremely rare. For instance, RMDs were suspended in 2020 due to COVID-19. But that exception has already expired and RMDs are back for 2021.
Early retirement options
No matter how it happens, if you retire early you may need to access funds in 401(k) before you’re 59.5. Your specific options may vary based on your situation, but in general, these are the options you have for withdrawing funds from a 401(k) before age 59.5 without the 10% penalty.
RULE OF 55
If you leave your job (voluntarily or not) during or after the year that you turn 55, you may be able to take distributions from your current 401(k) without penalty. Note that not all 401(k) providers allow this, so it depends on where you work. Also not that this is only for current accounts. Old 401(k)s from prior employers are not eligible. If your 401(k) doesn’t allow this, or if you don’t turn 55 during or before the year that you stop working, you’ll need to use one of the other methods below to access your 401(k) funds without penalty.
RULE 72T (SEPP)
One thing to note about setting up 72t/SEPP withdrawals is that the calculation is based on the dollar amount of the specific account that you choose. You do NOT have to use the total of all your retirement accounts. So, if you have a few IRAs, a current 401(k), and an older 401(k) from a previous employer, you can choose to take SEPP withdrawals from only one or two of those accounts. This can be a good way to choose the amount of your required withdrawals, keeping it in line with what you’ll need for expenses without dipping too far into your retirement reserves. Remember, leaving as much as possible in your retirement accounts for as long as possible can significantly increase your overall returns.
ROTH CONVERSION LADDER
Old 401(k)s and rollovers
If that answers your question, great! If you want to learn more, keep reading. I’ll go step-by-step through the process I would take if I were considering a 401(k) rollover.
STEP ONE: DECIDE WHY YOU WANT TO ROLL OVER YOUR OLD 401(K).
If I am unhappy with the fees or the investment options at my old 401(k), then I can consider a rollover. HOWEVER, the rollover does NOT have to be into a 401(k) at my new employer. That brings us to…
STEP TWO: DECIDE WHERE MOVE THE OLD 401(K) FUNDS
If you choose to set it up as a Roth IRA, there are still no penalties, but there will be taxes. Roth IRAs are funded with after-tax dollars, grow tax-free, and then unlike 401(k)s and trad IRAs, distributions from Roth accounts are also 100% tax-free. One additional benefit of rolling over to a Roth IRA is that after five years, you are allowed to withdraw your initial rollover amount with zero penalty, and zero additional taxes. (Remember, you already paid income taxes on the amount of the rollover at the time of the rollover.)
Creditor protection: Some folks might be concerned about the creditor protection differences between 401(k)s and IRAs. In case you didn’t know, 401(k) accounts are nearly completely protected from creditors in the case of bankruptcy or lawsuits. Only the IRS, an ex-spouse in a divorce proceeding, or a couple of other very rare and specific cases can make claims on the funds in a 401(k). IRAs have different protections that are not always as comprehensive, depending on which state you live in. In all states, funds rolled over from a 401(k) to an IRA keep their bankruptcy protection. Non-bankruptcy protection (this is generally protection in the event of a lawsuit or other court order) can vary from state to state, though. Most states protect IRA funds from lawsuits just as much as your 401(k) would be protected. Others have a lower level of protection. So, you’ll want to check out your state law if you’re concerned about this.
Company stock: Many companies allow employees to access company stock in their 401(k)s. There are some significant tax benefits to just keeping this stock in that 401(k). Another option with similar tax benefits is to roll that stock over to a regular brokerage account instead of an IRA. This can get complicated, but if you do it right, then when you eventually sell that stock, you will pay long-term capital gains taxes on it, instead of regular income as you would if you rolled your whole account into an IRA. And long-term capital gains taxes are almost always lower than regular income taxes. If this situation applies to you, I would recommend working with a tax professional to make sure it’s done right.
Are you over 55 years old, but less than 59.5? If you are, and you are no longer employed, 401(k)s allow for penalty-free distributions. If you roll into an IRA, however, you’ll have to wait until you’re 59.5 before you can withdraw without penalty.
STEP 3: MAKE THE ACTUAL TRANSFER
When a 401(k) cuts a check to you, they will almost always withhold about 20% for taxes. The only way to get that 20% back is via your tax return. So, until then, you will have to cover the difference from your savings. That means that if you trying to roll over an account worth $100,000, and the check is made out to you, it will be for $80,000. You will have have to contribute the additional $20,000 from your own savings in order to make the rollover complete, and then get reimbursed via your tax return. If you don’t cover the $20k, that portion will be considered a distribution, and you will have to pay taxes and penalties on it. Finally, you have to ensure that all of the funds are deposited into the new retirement account within 60 days, otherwise it will be considered a distribution and you will owe taxes plus a 10% penalty on whatever balance of the rollover is not in the new account.