The 401(k): How to Make Sense of One of America’s Most Prominent Retirement Plans
The Decline of the Pension and the Rise of the 401(k)
Once upon a time, the world of employee-sponsored retirement accounts was ruled by pensions.
If you were a typical American worker in the middle of the 20th century, and you worked at the same company for most of your career, you could expect to receive a pension upon retirement. Pensions were very simple: your employer would pay you a certain amount every month, known as a defined benefit, for the rest of your life.
Over the past several decades, however, pensions for private sector workers have dramatically declined for a variety of economic and social reasons. They have largely been replaced with 401(k) plans.
Unlike a pension, a 401(k) is a defined contribution plan. That means that you make a set contribution to the 401(k) every month until you retire, but there is no guarantee of a defined benefit from the plan.
Back in the day, companies would generally pay your pension every month until you died, even if you outlived your life expectancy. Companies were willing to take this risk upon themselves as a reward for employees showing loyalty to a company for most of their careers. But with a 401(k), you must make the money within the account last until you die. If you run out, there will be further funds.
401(k)s are more complicated than pensions in other ways, too, and that is why it is important to understand them. Used properly, they can be an invaluable tool for retirement planning, but there are a number of pitfalls to avoid.
Although 401(k)s are now the most common employee-sponsored retirement plan, used by millions of Americans, we’ve found that there are a surprising number of misconceptions about what they are and what they can and cannot do. In this article, we will explain how 401(k)s work, the different types of 401(k)s, and the asset protection benefits they provide.
What Is a 401(k)?
Their Surprising History
The name 401(k) is taken from a section of the Internal Revenue Code.
However, the 401(k) plan as we know it was essentially created by one man, benefits consultant Ted Benna, in 1980. Section 401(k) had been implemented two years earlier for reasons completely unrelated to retirement plans, but it was Benna who figured out how to best take advantage of that particular code.
It’s rare for one single consultant to have a broad impact on the interpretation of the law, but Benna completely changed the way in which Americans plan for retirement. In fact, Benna ended up changing the rules even more than he had initially anticipated. While 401(k)s were originally intended to be supplements to pensions, they ended up becoming substitutes for them.
Basics of a 401(k)
Traditional 401(k) plans allow an employee of a company to defer part of their paycheck into a special 401(k) account. The income deferred into this account is not taxable, instead, it will be taxed upon withdrawal, once you have retired.
You can contribute to the 401(k) at any level you choose, up to the limit set by the IRS. This limit is changed regularly to keep pace with inflation. As of 2019, the limit is $19,000 annually, and if you are over the age of 50, you can make “catch up contributions” of an additional $6,000 each year. 401(k) contributions may be matched by your employer.
When you deposit money into a 401(k), it is invested. The precise type of investments will differ, although they usually include stocks and bonds as well as other types of investments. This means that your assets within a 401(k) will likely (although by no means certainly) increase over time, so that they are worth significantly more upon your retirement than when you invested them.
Major Benefits of a 401(k)
The first major benefit of a 401(k) is the tax deferment. You do not have to pay taxes on the money placed in a 401(k) until you withdraw it.
What’s the point of a tax-deferred plan if you’re going to have to pay taxes later anyway? Well, there are a couple of benefits:
• When you pull funds from a 401(k) during retirement, you will only be obligated to pay taxes according to your income for that particular year. Once you have retired, your income will likely be much lower, meaning that you will fall in a lower tax bracket than you would have during your career.
• When you deposit money in a 401(k), this lowers the amount of money that is taxable in the present, meaning that you will be taxed less than you otherwise would without a 401(k).
Essentially, 401(k)s spread things out so that you pay far less in taxes, both now and once you have retired.
The other major benefit of a 401(k) is matching contributions. While the money you place in the 401(k) account is primarily your own, your employer may match your contributions. The amount that they match will vary, but this provides you with an incentive to contribute a larger share of your money, in order to get the full amount of matched contributions.
Your employer’s contributions to a traditional 401(K) may either be fully vested at once, in which case your 401(k) will have the full amount immediately, or else they will be subject to a vesting schedule whereby the full amount will not be deposited into your account until after a set period of time.
Cautions with a 401(k)
The most significant caution with a 401(k) is that the account must actually be used for retirement purposes.
If you withdraw funds from your 401(k) account before reaching the (somewhat arbitrary) age of 59 ½, then you will typically have to pay fairly significant taxes and a 10% early withdrawal penalty on the money you take out.
Some people habitually raid their 401(k) accounts before retirement in order to pay for routine expenses, but this is one of the worst possible financial decisions you can make. While early withdrawal is an option, it should be reserved for only the direst of emergencies. 99% of the time, it’s better to leave the money where it is.
Not only is there a minimum age for beginning to withdraw from a 401(k), but there is a maximum age as well. Generally, you must begin withdrawing a minimum monthly benefit from your 401(k) by the age of 70 ½, or face penalties.
Another caution with a 401(k) is that it can be somewhat risky. Your money will be invested into a portfolio of financial instruments, including some fairly high-risk investments such as stocks. While it is likely that this will increase your money, if the investments are made thoughtlessly then you may lose money rather than gain it. When you are employed by a company that offers 401(k) benefits, it is worth doing a little research and finding out exactly where your money will be going.
Finally, while the above rules generally apply to all traditional 401(k) plans, this does not mean that they are the only rules you will have to consider. Each plan is different, and your employer may have added some additional stipulations that you will have to follow. Don’t assume that you know anything about the plan until you read it.
Variations on the 401(k)
So far, we’ve described how the traditional 401(k) plan works. But in fact, there are several variations of the plan which you may encounter:
- If you are a sole proprietor rather than an employee, you can set up a solo 401(k). the major benefit of this is that you can double up on contributions as both the employer and employee, thereby investing twice as much as you would otherwise be able to.
- A Roth 401(k) is the inverse of a traditional 401(k). Your contributions to the Roth 401(k) are not tax-deductible, but once you withdraw the money, you will not have to pay any taxes on it. Whether or not to choose this option will depend on your personal situation. It is generally a good idea if you are younger and if you believe that you will be in a higher tax bracket once you reach retirement age than you are in at present.
- A Safe Harbor 401(k) provides an assurance that all employees receive a certain minimum contribution from their employer every month. In exchange, the employer does not have to spend as much of its resources on passing federal non-discrimination tests. Employer contributions, however, are fully vested: the employer cannot forfeit the contributions once they have been made.
- A Savings Incentive Match Plan for Employers, or SIMPLE 401(k) is for smaller businesses, specifically those with 100 employees or fewer. As with the Safe Harbor 401(k), the employers’ contributions are fully vested immediately and the plan is not subject to federal non-discrimination tests. However, the contribution limits ($13,000 as of 2019) are lower than those of a traditional 401(k), and the SIMPLE 401(k) cannot be used in conjunction with any other employer-sponsored account.
In addition to these different types of 401(k)s, there are a few completely separate types of plan which are similar to the 401(k):
- The 403(b) plan offers many of the same benefits of a 401(k), including tax-deferred status and matching contributions by employers. However, the 403(b) is used for a few specific classes of people, including nonprofit employees, some religious clergy, and certain employees of the government, particularly public school teachers.
- The 457 plan, like the 403(b), is used by certain types of public employees. The 457 comes with a few additional benefits, including a lack of penalty for early withdrawal. In addition, if your employer offers a 457 and a 401(k), you may contribute the maximum to both, potentially doubling your retirement savings. The 457 plan, however, may come with certain other stipulations.
- Individual Retirement Accounts (IRAs) are another type of plan altogether, although they sometimes get confused with 401(k)s. As the name suggests, an IRA is set up by an individual and is not tied to an employer. IRAs have many of the same tax benefits of a 401(k), although they lack some of the asset protection benefits offered by a 401(k), as we will explain below. There are a few different types of IRA, and you can set up an IRA in addition to a 401(k).
401(k)s and Asset Protection
The importance of asset protection in our society cannot be overstated. Tens of millions of lawsuits are filed every single year in the United States, and certain professions, such as doctors, are targeted disproportionately. California in particular is a hotbed of lawsuits.
Since many people’s largest chunk of savings is in their retirement account, you will want to do all that you can to protect it. Fortunately, the asset protection benefits legally afforded to 401(k) plans are very good.
The protection afforded to 401(k)s can be traced back to the Employee Retirement Income Security Act of 1974 (ERISA). This law stipulates that certain qualified plans are protected from most creditors and even from bankruptcy.
The good news is that 401(k) plans are considered qualified plans under ERISA. (Although Section 401(k) of the Internal Revenue Code was passed several years after ERISA, the plans still meet the qualifications necessary to be protected.)
There are only a couple of major exceptions to the protection afforded by ERISA:
• 401(k)s are considered marital property, which means that if you get a divorce, the assets in the 401(k) will not be protected from your spouse.
• 401(k)s are not protected from the government, which means that your assets may be seized if you owe federal taxes or other fees, such as criminal fines, to the federal government.
What’s more, ERISA protections have the ability to carry over into other retirement accounts.
What does this mean? Let’s take IRAs an example. Unlike 401(k)s, IRAs are not qualified under ERISA, and therefore receive no special federal asset protection. The level of asset protection that you will receive with an IRA varies from state to state. Some states offer significant protection for IRAs, but in California, the assets within your IRA will only be protected to the degree that they are necessary to support you and your dependents once you have retired… and this is typically interpreted fairly narrowly.
Now, let’s say you choose to roll over some or all of your assets within a 401(k) or other ERISA-qualified plan into an IRA. If you do this, the assets within the rollover IRA will remain protected, even in a state like California which offers no special protection to IRAs. All you will need to do is provide documentation showing that the assets in question in the rollover IRA originated in a 401(k).
This allows you to enjoy some of the benefits of an IRA, including greater flexibility, without exposing your assets to undue risks.