What is a 401(k)?
A 401(k) is a type of investment account sponsored by an employer and designed to assist employees in saving for retirement.
It allows employees to take money from their paycheck before taxes have been applied (pre-tax income).
The 401(k) is an extremely popular tool retirement-savings tool because it is tax-advantaged relative to other types of investment brokerage accounts or savings accounts.
The 401(k) plan gets its name from the section of the tax code that defines the rules for it.
401(k) Plans Have Significant Tax Benefits
401(k) plans help lower a participant’s taxes in two ways.
Key Benefit #1
First, contributions made to a 401(k) plan reduce your total taxable income for the year.
So if you made $50,000 and contributed $5,000 to a 401(k) plan, your taxable income would be reduced to $45,000. This means you would only pay federal income taxes (and most state taxes) on the equivalent of a $45,000 salary while you pocketed the savings in the form of a retirement account.
Account holders do not have to pay taxes on the income contributed until they make withdrawals from the 401(k) account.
Key Benefit #2
Second, once your contribution has been made to a 401(k), it grows without the burden of incurring taxes on realized capital gains or dividends until the money is withdrawn from the account.
So not only are contributions made from pre-tax income (protecting savings from income taxes), but investments grow for many years avoiding capital gains taxes, which can be as high as 30 to 40 percent of gains annually for a standard taxable investment account.
The tax benefits really add up, but there are some limitations.
Most significantly, 401(k) plan participants cannot withdraw from their investment account until the age of 59½.
If a participant withdraws early, a tax penalty of 10 percent is applied in addition to taxes owed on income and investment gains.
Also, the IRS limits the amount of income that can be contributed to a 401(k) account. The limit for 2019 was $19,000, but the IRS changes the limit from time to time. If you are 50 or older, you can contribute an additional amount referred to as a catch-up contribution.
401(k) Plans vs. Pension Funds
401(k) plans have largely replaced employer pension funds, which are also retirement plans sponsored by employers.
There are key structural differences between 401(k) plans and pension funds.
Although 401(k) plans are sponsored by an employer, employee participation is optional. Employees dictate what portion of their paycheck they would like to contribute to the retirement account.
For this reason, 401(k) plans are classified as defined contribution plans. Some employers offer a contribution match where they will contribute additional money to an employee’s 401(k) to incentivize them to save for retirement.
Once an employee has contributed to a 401(k) account, the employer provides a menu of investing options and the employee chooses which investments to allocate their funds to. Whether 401(k) funds are invested conservatively or aggressively is up to the employee. The employer does not guarantee the investment results.
By contrast, a pension fund is a retirement benefit for employees that is solely controlled by the employer.
The employer determines how much to contribute to the investment assets and how the investments are managed. The employer guarantees a certain level of retirement benefits to the employee. For this reason, pension funds are classified as defined benefit plans.
They put the burden of paying retirement benefits on the company.
Some companies find themselves in poor financial position and become unable to pay out the retirement benefits promised to employees. This is a major reason why many companies and employees prefer 401(k) plans.
Another benefit of 401(k) plans is that the employee can take their plan with them to a new job without fear of losing it, which sometimes happens with pensions that take many years to vest. However, if an employee doesn’t contribute enough or poorly invests their 401(k) funds, they may be left with few assets at retirement.
The graphic below summarizes the differences between 401(k) plans and pension funds.