The 401 K Rules, Regulations, and Options

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What’s better than knowing you’re doing a good job saving for retirement? 401(k) employer-sponsored retirement savings plans can be key when saving for your retirement.

The name 401K comes from the section of the Internal Revenue Code the governs the plans. They are commonly offered as part of a job benefits package. Employees may save a portion of their salary in a 401(k) account, subject to annual limitations. This powerful contribution plan can help you save and invest for retirement. You decide how much to contribute to your account and which investments to choose. And if your lucky, your employer may match part of your contributions.

Let’s take a look at some rules, regulations and options when it comes to 401(K) savings plans.

401(K) Contributions are Tax Deductible or Can Grow Tax Free

There are two type of 401K plans. The first is the Traditional 401(k). The traditional 401(k) has long been a staple in retirement planning for millions of Americans. The second is a Roth 401(k). The Roth 401(k) is a relatively newer option that offers tax free growth. Let’s take a look at both.

The Traditional 401(k)

Contributions to your 401(k) are made on a pretax basis. As a result, the IRS allows you to deduct those contributions from your taxable income. Sweet!

Another advantage: 401(k) contribution limits are much higher than an IRA – up to $23,000 per year for 2024. And, if you’re over age 50, you can make an additional catch-up contribution of up to $7,500.

The neat thing about 401(k) contributions is that every dollar you add
helps reduce your taxable income. Suppose you and your partner earn $100,000 as a household and contribute $20,000 to your 401(k)s. Those contributions could reduce your taxable income from $100,000 to $80,000 – which can mean big tax savings come April 15!

Remember, since you didn’t pay taxes on your 401(k) contributions, expect to pay Uncle Sam when you take the money out. Fortunately, there are ways to structure your 401(k) distributions to potentially minimize your possible tax liability.

The Roth 401(k)

Contributions to a Roth 401(k) are made with after-tax dollars, meaning you pay taxes on the money before it goes into your account. While this means you don’t get an immediate tax break, it sets the stage for tax-free withdrawals in retirement.

Perhaps the most significant benefit of a Roth 401(k) is that qualified withdrawals in retirement, including both contributions and earnings, are entirely tax-free. This can provide significant tax savings and flexibility in retirement, especially if you anticipate being in a higher tax bracket in the future.

Unlike traditional 401(k) plans, Roth 401(k) accounts are not subject to required minimum distributions (RMDs) during the lifetime of the original account holder. This means you can let your savings continue to grow tax-free for as long as you like.

Employers Usually Offer a Matching Contribution

Employers who provide a 401(k) for their employees usually offer some sort of matching monetary contribution if you participate in the plan.

How much an employer may match depends on the terms of your specific 401(k) plan. Other than ensuring the plan conforms with ERISA regulations, the employer match is at the discretion of company management. Some employers match contributions dollar for dollar, while others match 25 or more cents on the dollar. Frequently, an employer matches a certain percentage of your salary.

So, unless your company doesn’t match your contributions, you should absolutely take advantage of the opportunity to receive an immediate return on your investment (the “match” money from your employer) and accelerate your retirement savings.

There is usually a vesting schedule detailing how long you need to be employed before your employer’s contributions become yours to keep. It may be helpful to remember that vesting, in this sense, derives from the Latin word vestire, which means “to put into possession.” So, a vesting schedule is literally the timing for when the employer’s contributions become yours.

What Happens to Your Employer-sponsored 401(k) When You Leave the Company?

Even if your retirement plan isn’t top-of-mind when you resign, it’s important to fully understand the various plan rollover options.

• • • Roll it over – If your new job offers a 401(k) plan, you can roll your old 401(k) account into the new one through a direct transfer once you’re eligible. This allows you to keep your retirement money invested and avoids the risk of missing deadlines or owing taxes if you withdraw the money. Suppose you opt to
      have your old account send a check so YOU can deposit the money into your new retirement account. In that case, you usually have 60 days to deposit it (or risk owing taxes on that money). Making a rollover is a big decision and one to review with your financial advisor. If you are considering a rollover, reach out to discuss.
    • Take distributions – If you’re retiring from the workforce (and not changing jobs), it’s probably time to figure out how to withdraw from your 401(k). For example, you can begin taking qualified distributions after 59.5 (before that, you’ll pay a 10% tax penalty). Once you start using your 401(k) as income, you may owe income tax on the withdrawals you make.
    • Leave it alone – Depending on how much is in your account, leaving it with your current employer may be one option. A balance of $5,000 is often enough for companies to let you keep your account with them. This could be good if you like your investment options or don’t want to deal with your account
      while handling other factors involved in a job change. But, if your decide to leave it alone make sure you keep good records and keep your contact information updated so you don’t lose track of your money.

No matter which option you choose it’s important to understand the rules for each option to avoid unnecessary fees and taxes.

Withdrawals to Help with the Unexpected

Life often has a way of throwing us curveballs when we least expect it. Hopefully, you’ve done a good job setting aside money to deal with the unexpected, but what if you haven’t? Is it possible to obtain money from your 401(k) account to address a financial need? While it’s not ideal, it is possible to access the money in your account before retirement. The three most common ways to access 401(k) funds are hardship withdrawals, non-hardship withdrawals, and loans.

• • • Hardship Withdrawals
      If you have money in your current employer’s 401(k), you usually have an opportunity to access those savings under certain hardship conditions. The drawback, however, is that qualifying for this provision can be challenging. Just as the IRS has its list of qualifying financial hardships (medical expenses or disability), individual plans often do as well. That means you must qualify under both rules, which may be more difficult. Another drawback of a hardship withdrawal before age 59.5 is the 10% penalty on whatever you’ve withdrawn. The withdrawal is also taxed as income. Taxes and penalties can make a hardship withdrawal expensive.
    • Non-Hardship Withdrawals
      Not every plan allows non-hardship withdrawals. If yours does, you have an opportunity to take money out of your account and redistribute it as you see fit. Generally, the best bet is to roll the amount into an IRA. You avoid taxes, and you have a larger range of investment options, with potentially lower administrative fees.
    • Loans
      A loan may be your only remaining option if you’re in a bind. A 401(k) loan allows you to borrow against your savings. Some plans have use restrictions similar to those for hardship withdrawals. The loan must be paid back, usually within five years, and a loan cannot be rolled over into an IRA. However, if you leave a company and still have an outstanding 401(k) loan, you’re often required to pay it back quickly, usually in one to two months.

Early 401(k) withdrawal can carry significant tax and personal consequences that should be balanced against your current needs and long-term financial goals. Do not make this decision lightly. Discuss all options with your financial advisor.

Deciding between a traditional 401(k) and a Roth 401(k) depends on various factors, including your current tax situation, expected future tax rates, retirement goals, and personal preferences. Some individuals may benefit more from the immediate tax break of a traditional 401(k), while others may prefer the tax-free withdrawals of a Roth 401(k) in retirement. Feel free to reach out to our office today to review your current 401(k) strategy and ensure it aligns with your long-term goals. As always, we are here to help!

**The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation.