Retirement planning is a tricky thing for many Americans. Retirement involves a person making the choice to leave the workforce. However, once a person leaves the workforce, that means they lose their source of income. Without a consistent source of income, many people cannot keep up with their bills like a mortgage, a car payment, etc. In fact, many people don’t even realize that there are a lot of different accounts that can help them reach their goals. One popular option for retirement savings is a 401(k) plan.
What is a 401(k) Plan?
This specific retirement account is only available to employees. That’s because employers are the ones who offer this option! This is popular amongst employees because it helps them save for retirement, comes along with tax benefits, and contribution benefits. These accounts are investment accounts. That means that the funds you contribute into the account will go towards investments. Usually the investment options available are limited by the options that the employer chooses.
Even though these accounts come with a variety of benefits, there are rules around these types of plans. One of the biggest rules are the contribution limits in place. In 2021 the contribution limits for a 401(k) were:
- $19,500 for people younger than 50 years old
- $26,000 for people older than 50 years old
On the other hand, the contribution limits for 2022 were:
- $20,500 for people younger than 50 years old
- $27,000 for people older than 50 years old
That means that these limits can change every year! It is important to be aware of these changes so you can make the most out of your 401(k).
Different Types of 401(k) Accounts
It’s also important to keep in mind that the type of plan will impact how it works. There are two main types of 401(k) accounts. There are:
- Traditional 401(k)s
- Roth 401(k)s
Understanding Traditional 401(k) Plans
Typically when people think of a 401(k) account, they are likely thinking of a Traditional 401(k). When an employee makes a contribution into this type of account, they will use pre-tax dollars. Why is that important? Since no taxes have been applied to the funds, that means that individuals can use the contribution as a tax deduction. Tax deductions are a benefit because they can reduce the taxable income of the employee. For example, let’s say an employee made a $3,000 contribution towards their Traditional 401(k) account. If their annual income for that year was $35,000 then they could apply the tax deduction and only pay taxes on $32,000 worth of income.
Like we said earlier, there are rules that come along with these types of accounts. Besides contribution limits, there are required minimum distribution (RMD) rules. RMDs require the account holder to begin taking funds out when they are 72 years old. When a person takes funds out of their account, it is known as a distribution.
When you take out a distribution from your account, they will be taxed at the standard income tax rate (since the funds in the account are pre-tax). That means you can expect to pay taxes on what you take out! The standard income tax rate is determined by your income level. However, there are exceptions to this rule! For example, an exception would be if you were born before January 2nd, 1936 and choose to take your distribution out as a lump sum.
Understanding Roth 401(k) Plans
Now that you have a better understanding of Traditional 401(k) accounts, it is time to get a better understanding of Roth 401(k) accounts. The funds that people put into this account are after-tax. That means that taxes have already been applied to the funds before they are placed into the account. However, even though a person will not be able to see the tax benefits right away, they will see them down the line. That’s because the distributions that you take out of this account will not face any additional taxes! Just like with a Traditional 401(k) account, there are rules that come along with Roth 401(k) accounts. Besides contribution limits, there are required minimum distribution (RMD) rules. RMDs require the account holder to begin taking funds out when they are 72 years old.
When taking funds out of a Roth 401(k) account, it is important to remember that the distributions must be qualifying. Qualifying distributions meet requirements like:
- 5 years have passed since the account holder opened and deposited funds into their account
- The account holder is at the retirement age for this account which is at least 59 and ½ years old at the time of the distribution.
What are the Pros and Cons of a 401(k) Plan?
Just like anything you consider in life, you will want to make sure you look at the pros and the cons of this plan. Let’s start off by looking at the pros! Some of the benefits that come along with this retirement account are:
- Federal Legal Protection
- Potential Employer Matching
- High Yearly Contribution Limits (If Offered)
- Free Investment Advice
While these are some nice benefits, there are some drawbacks to be aware of as well. Some of the cons that come along with this type of account include:
- Potentially Limited Investment Options
- Potentially Higher Account Fees
- There May be Early Withdrawal Penalties
While these drawbacks may not necessarily outweigh the benefits, it just depends on the person. For example, if you are someone that doesn’t want to deal with limitations when it comes to your investment options, then you may not like a 401(k). That’s because instead of being able to invest in whatever you want, you may be limited by the investment options that the employer chooses.
What are 401(k) Alternatives?
Earlier we said that only employers offer 401(k) plans. That means that if your employer doesn’t offer one, you will not be able to benefit from this option. However, there are other opportunities to consider! An alternative to 401(k) plans are Individual Retirement Accounts (IRAs). Just like 401(k) plans, there are two types of accounts that you can choose from. You can choose either a:
Just like 401(k) accounts, there are contribution limits that people will deal with. For example, in 2021 (and 2022) the contribution limit for an IRA is :
- $6,000 for individuals younger than 50 years old
- $7,000 for individuals older than 50 years old
What is a Traditional IRA?
Just like a Traditional 401(k), these accounts use pre-tax funds towards investments. The Internal Revenue Service (IRS) will not assess capital gains or dividend income taxes on these accounts until funds are taken out. That means that the funds in these accounts grow tax-deferred! Once it is time to make a withdrawal the account holder should be at least 59 and ½ years old.
Typically the contributions that a person makes into these accounts can be considered as a tax deduction. For example, let’s say you contribute $2,000 into your Traditional IRA. In that same year, your taxable income was $40,000. Instead of paying taxes on $40,000, you can use the tax deduction of your contribution to reduce your taxable income to $38,000.
However, just like with a Traditional 401(k) the tax savings are seen at the beginning with the tax deduction. When it comes time to take funds out of the account, they will be taxed at the standard income tax rate.
What is a Roth IRA?
Besides a Traditional IRA, there is a Roth IRA. Just like a Roth 401(k), these accounts use after-tax funds. However, since the funds that go into the account already deal with taxes, that means individuals have the chance to make tax-free withdrawals. In order for the withdrawals to be made at the tax-free rate, they need to be eligible.
In order for the distribution to be eligible they will need to meet factors like:
- 5 years have passed since the account holder opened and deposited funds into their account
- The account holder is at least 59 and ½ years old at the time of the distribution.
- Funds taken out are used towards rebuilding or buying a first home for the account holder or qualifying family member (this has a $10,000 lifetime limit)
- The account holder becomes disabled
- Assets go towards the cost of having or adopting a child
If none of the above conditions are met, then the distribution will not qualify to be tax free. Besides dealing with income tax, there will also be up to a 10% penalty. Luckily, there are also exceptions to the tax rate and penalties. For example, if the funds go towards any of the following then it would be considered an exception:
- Unreimbursed Medical Expenses: The distribution must be over 7.5% if the person’s AGI (adjusted gross income).
- Medical Insurance: As long as the person is unemployed.
- Eligible Higher Education Costs: This includes fees, tuition, books, supplies, etc.
- Childbirth or Adoption Expenses: As long as the distribution was made within one year and isn’t more than $5,000.
Commonly Asked Questions
Understanding 401(k) plans and their alternatives can be a lot for many people. That is why when learning about this topic other people had questions along the way. If you have questions too, then you’re not alone!
Are 401(k) Accounts Worth It (Even If They Don’t Offer Employee Matching Programs)?
Any account that can help you towards your retirement goals is worth it. Regardless of the type of 401(k) plan you choose, the funds ultimately go towards your retirement. Whether or not an employer will match the funds you put in, you shouldn’t bank on that benefit specifically. Instead, focusing on saving for your retirement will make the account worth it!
What is the Best Account for Retirement Savings?
The best account will depend on your goals and other factors like your situation, your income, etc. If your employer doesn’t offer a 401(k) account, then you will not be able to choose this option. In order to truly find the best account, you will want to confirm with a professional like a certified financial planner or a financial advisor.
Can a Certified Financial Planner Help?
While an article online is a great place to start your retirement planning journey, it should not be the end all be all. Instead, you will want to get help from a professional. Financial planners that are certified are a great option because they can help you plan out your financial goals from a professional standpoint. Another great option to consider would be a financial advisor!
Which is the Best Retirement Account for Me?
We know we will sound like a broken record but we just want to help you get the best account for your goals. In order to find the best option for your situation, goals, and circumstance, you will want to get in touch with a professional like the ones we listed above.
Is Retirement Planning Hard to Do?
It depends! Every person is different in how they view how “hard” something is to do. However, a lot of the toughness that comes along with planning for retirement comes from a lack of knowledge. That is why reading articles like this one can make a world of difference. It can also be easier to plan for retirement with the help of a professional to guide you along the way!