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Thayer Partners Blog

Retirement Planning FAQs: What is a 401k?

[fa icon="calendar"] Nov 4, 2015, 8:00:00 AM / by Chris Wilmerding

Chris Wilmerding

The definition of a 401(k) plan on paper written in black inkWhile most people are somewhat familiar with the concept of a 401k plan, you’d be surprised at how many people don’t know much about this retirement savings vehicle and how it works.

I often field questions about 401k plans from both employers and employees from different companies, with the big ones being “what is a 401k plan, exactly?” and “how do 401ks work?”

To help you answer your own questions, here are a few things that you should know about 401k plans:

What is a 401k, and How Does It Work?

At their most basic, 401k plans are retirement savings vehicles that allow employees in a company to defer, or delay, some of their pay. The pay that is taken out of an employee’s paycheck is set aside in an investment account. In a traditional 401k plan, this money is deposited pre-tax and isn’t taxed until it gets distributed.

While an employer might pull the money for a 401k plan out of an employee’s paycheck, the employer generally doesn’t actually manage the investment of the money. Instead, the company, or plan sponsor, hires a different company (such as Vanguard, Fidelity, ING, etc.) to administer the plan and sends the payroll deductions directly to this third party.

Ideally, the invested money will grow in the years up until the employee reaches retirement age and begins taking distributions from the account. However, as with any investment, there is a risk that the invested money may decrease in value, or that the principal invested will be lost entirely.

There are limits on how much money you can contribute to your 401k plan each year. This amount changes depending on the type of 401k plan being invested in and the age of the employee. Additionally, these limits may be updated from time to time. According to the irs.gov website, the limits are:

  •  $18,000 in 2015 and 2016 [for traditional and safe harbor plans]
  • $12,500 in 2015 and 2016 [for a SIMPLE 401k plan]

Contributors age 50 and over can add an additional “$6,000 in 2015 and 2016 to traditional and safe harbor 401(k) plans” or an extra “$3,000 in 2015 and 2016 to SIMPLE 401(k) plans.” These are called catch-up contributions, but you don’t have to be considered behind on your plan contributions to set aside the extra amount.

What are the Different Types of 401k Plans?

You may have noticed in the previous section that contribution limits on a 401k vary by the type of plan being invested in. This leads me to the next most common question I hear about 401ks, “what kinds of 401k plans are there?”

Generally speaking, the major types of 401k plans are:

  •  Traditional 401k Plans. These are the tax-deferred plans that most people think of when they think about 401k plans. Employers may or may not match contributions in a traditional plan. Under these plans, contributions have to pass specific tests to demonstrate that the plan doesn’t discriminate in favor of highly-paid employees.
  •  Safe Harbor 401k Plans. Safe harbor 401k plans have many similarities to traditional plans, with a few key differences. One of the major differences  noted by the IRS is that a safe harbor plan “must provide for employer contributions that are fully vested when made.” In other words, if the plan is Safe Harbor, the employer contribution will vest immediately.
  • SIMPLE 401k Plans. Like a safe harbor plan, the SIMPLE 401k plan requires employers to make fully-vested employer contributions. However, these plans are not subject to the same annual nondiscrimination tests that are required under other 401k plans, making them more appealing to smaller companies with a small or nonexistent HR team. However, according to the IRS, these plans are “available to employers with 100 or fewer employees who received at least $5,000 in compensation from the employer for the preceding calendar year.” Basically, these plans are optimized for small businesses.

In addition to these types of 401k plans, some 401k plans allow for a Roth feature to be added to the account. Using this “Roth 401k” option, employees pay the taxes on their contributions up-front, but their withdrawals from that account will be tax-free during retirement.

What Are the Rules for Taking 401k DIstributions?

Many people want to know what the exact rules are for taking distributions from their 401k. According to the irs.gov website:

“distributions of elective deferrals cannot be made until one of the following occurs:

  • You die, become disabled, or otherwise have a severance from employment.
  •  The plan terminates and no successor defined contribution plan is established or maintained by the employer.
  •  You reach age 59½ or incur a financial hardship.”

The distributions mentioned by the IRS can either be periodic, taking place over time, or non-periodic, wherein the full amount of the value of the plan is distributed immediately.

The conditions for distributing the value of 401k are designed to protect employees from losing the money invested, without making access to the money easy. In most cases, if you withdraw money from the 401k plan before reaching age 59½, you’ll incur a 10% penalty (in addition to ordinary income tax). However, there are exceptions to this.

One example cited on money.usnews.com is that “there is a special provision in 401(k) plans for people who leave their employer after they reach age 55 but before they reach age 59 ½. This rule allows you to take withdrawals that are exempt from the penalty tax without having to use the substantially equal payment provision.”

Another instance where you wouldn’t incur a penalty is when you roll over your 401k plan’s funds into an individual retirement account (IRA) after leaving your employer. Such an event is not taxable, and some advisors suggest consolidating your 401ks into a single IRA if you have plans from multiple ex-employers to make managing the assets easier.

One last thing to keep in mind is that there exist “required minimum distributions” for 401k plans. According to the IRS, distributions usually are required to begin no later than the “calendar year in which you reach age 70 ½” but no earlier than age 59 ½. Although, under certain circumstances, you may still have to take distributions of your 401k plan after you reach age 70 ½, even if you’re still working.

There are many other rules that apply to 401k plans, too many to cover them all here. If you have more questions about 401ks, consult with a retirement or financial planning expert to go over these valuable retirement savings vehicles in detail.
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Topics: Retirement, 401k

Chris Wilmerding

Written by Chris Wilmerding

Chris Wilmerding is Principal of Thayer Partners, an independent investment management firm located in Westwood, MA providing financial planning and wealth management counsel to individuals and their families.

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