In the United States, a 401 (k) is a type of pension account. It is called 401 (k) since it is define in subsection 401 (k) of the Internal Revenue Code. A 401 (k) pension account is a tax-qualified, defined-contribution account.
Under a 401 (k) plan, retirement savings are deducted from an employee’s paycheck before taxation. The money is thus tax-deferred until they are withdrawn from the account later. There is a limit to how large the pre-tax contribution is allowed to be per year. At the time of writing, the maximum is $18,000 per year.
Many employers will proportionately match the employee’s contributions to the 401 (k).
The 401 (k) is not the only employer-provided defined-contribution plan available within the United States. Examples of other plans are the 403 (b) plan which is for the employees of non-profit organisations and the 457 (b) plan which is for the employees of governmental employers. For more information, se section 401 (a) of the Internal Revenue Code.
It is also a good idea to take a look at Individual Retirement Arrangement (IRA) plans when one is planning for retirement. The selection of investment vehicles tend to be bigger and more diverse with IRA plans than with employer plans. Also, many IRA plans come with considerably lower fees than the average employer plan.
No government deposit insurance
It is important to keep in mind that there is no government deposit insurance for assets held in a 401 (k) account.
Bankruptcy laws give a high priority to 401 (k) liabilities, but that is only helpful if there are sufficient funds available to completely or at least partly cover such liabilities when the entity files for bankruptcy.
A rollover can be carried out from one eligible retirement to another, e.g. when an employee is changing from one employer to another. A direct rollover is not taxed.
As mentioned above, there is no government deposit insurance for 401 (k) assets. This is important to keep in mind. In some situations, leaving assets in the old plan instead of doing a rollover is better. There is also the possibility of an individual retirement arrangement (IRA).
Earnings from investments in a 401 (k) account are tax-deferred. This is true for earnings in the form of interest, dividends and capital gains. It doesn’t matter if the contributions were pre-tax contributions or after-tax contributions. The delayed taxation means that assets are left in the 401 (k) where they can earn interest, dividends and capital gains, instead of being taken out to pay taxes. This one of the major benefits of the 401 (k) plan.
The employee does not pay federal income tax on pre-tax contributions to the 401 (k) account. However, the employee must still pay payroll taxes (Social security and Medicare). At the time of writing, this amounts to 7.65 percent.
Sarah earns $50,000 this year. She defers $4,000 into her 401 (k) account.
This means that Sarah will only report $46,000 in income for that year. If Sarah is in the 25% tax bracket and there are no other adjustments, this means that by deferring, Sarah avoids paying $1,000 in taxes. ($4,000 x 0.25 = $1,000)
When Sarah eventually withdraws money from her 401 (k) account, she will pay tax on the withdrawn money.
After-tax contributions to a non-Roth 401 (k) account
If an employee makes after-tax contributions to a non-Roth 401 (k) account, that money is commingled with the pre-tax contributions and add to the non-Roth 401 (k) basis.
How to calculate the taxable portion of the distribution when distributions are made? It will be calculated as the ratio of the non-Roth contributions to the total 401 (k) basis. The rest of the distribution is tax-free and not included in the individual’s gross income for that year.
After-tax contributions to a Roth 401 (k) account
For accumulated after-tax contributions and earnings in a designated Roth 401 (k) account, certain distributions can be made tax-free if certain requirements are met.
- Distributions must be made more than 5 years after the first designated Roth contribution.
- Distributions must not be made before the year in which the owner of the Roth 401 (k) account turns 59 ½.
- N.B! Exceptions to the general requirements are found in IRS code section 72 (t).
You might have heard about the upper income limit cap for Roth IRAs, but for Roth 401 (k) contributions there is no such cap. This means that if you aren’t allowed to have a Roth IRA you can contribute to your Roth 401 (k) instead.