Why the 401(k) is the best investment for employees 

As many American workers and investors continue to provide for themselves and their families, they also work to build a nest egg for their retirement. One retirement plan stands out: the 401(k) plan.  

Designed to provide employees with a savings vehicle for their golden years, a 401(k) plan offers unique tax benefits to plan holders. This is why it can be an indispensable tool for long-term financial growth. 

 So how does a 401(k) plan work when you retire? When can the 401(k) be withdrawn? What happens to your 401(k) if or when you quit your job? In this article, InvestmentNews delves into the intricacies of the 401(k), tackling these questions and more.  

What is the 401(k) plan and how does it work? 

The 401(k) is an employer-provided retirement savings and investing plan offered to employees.  

An employee who is enrolled in a 401(k) can elect to have contributions to the plan automatically taken from their paycheck.  

In most cases, the employer does what’s called a “401(k) match” where they also contribute a portion or all of the amount into the 401(k). This essentially means that the employer “matches” their employees’ contributions to their retirement savings. Employees are then given a few investment choices, so the money can be invested in funds that will (hopefully) grow the money into a decent amount for their retirement. 

Employees get to decide which investments their 401(k) plan contributions go to, and what the allocations are. For example, they can choose to have:  

• 70% of the amount in an available Equity Index Fund 
• 20% in a Bond Index Fund 
• 10% in a Money Market Mutual Fund 

The way these allocations will be made ultimately depends on which investments are on offer, coupled with the employee’s risk appetite and financial goals.  

The IRS has designated the 401(k) plan as a “qualified plan”. This means that the plan comes with certain tax benefits that plan holders can and should take advantage of.  

What are the tax benefits of the 401(k) plan? 

There are two main tax advantages that the 401(k) offers:  

1. When employees make contributions to their 401(k), it’s done with pre-tax dollars. 

The money is placed into their retirement account before taxes are imposed. With these pre-tax contributions, every dollar that the employee saves will reduce their total taxable income by the same amount. The result is that employees will have to pay less income taxes for the year.  

For example: if an employee makes a $1,200 contribution to their traditional 401(k), that will reduce their gross income for that year for the same amount. Assuming they had a gross income of $50,000, that is reduced to $48,800 for that year.  

2. Employer matches to employee contributions and earnings in the account are tax-deferred. 

The amounts that employers place to match their employees’ contributions and the growth on the account are not taxed until they are withdrawn. Earnings include interest, dividends, and capital gains.  

Any elective deferrals that plan participants make are likewise tax-deferred.   

All this simply means plan participants won’t have to pay any tax on these funds until they withdraw the money from their accounts, usually upon retirement. While the employer match seems like an ordinary feature, it’s a major draw for employees to work at companies that have it.  

Speaking of the traditional 401(k)’s tax benefits, is it advisable to keep contributions there or roll over to a Roth IRA or Roth 401(k) to save on taxes? This video says the answer is not always a simple yes or no. There are other factors like the plan holder’s age, their retirement plans, and other factors. Watch the video for more insight.  

How does the 401(k) plan work for you in retirement? 

Once an employee reaches retirement age, they have a few options: 

1. Leave the money in the plan.  

If the account is worth at least $5,000, the money can remain in the plan even in retirement. Employees should remember that in retirement they can no longer make any more contributions to the plan.

2. Roll over to an IRA. 

Employees can opt to roll over their money from the 401(k) to another qualified retirement plan like an IRA. Plan holders can do a direct rollover or a 60-day rollover to an IRA.  

3. Withdraw as a lump sum.  

Upon retirement, plan participants can withdraw all the money from their 401(k) in one lump sum, keeping in mind that this will be treated as taxable income.  

4. Convert the plan into an Annuity.  

Some 401(k) plans offer the option of converting them into an annuity. This is known as the immediate annuity, and it converts the plan balance into monthly payments.  

While the income payout is guaranteed, the income may not meet the needs of some retirees. Remember, the income is still dependent on the paying ability of the employer. There may also be some drawbacks to this conversion, such as losing access to the principal amount in case of an emergency. 

What are the different types of 401(k) plans?  

There can be several types of 401(k) plans, but these are the most common:  

1. Traditional 401(k) 

This is what most people think of when asked about a 401(k) plan. In this plan, the employee contributes a portion of their paycheck. The contributions are usually via salary deductions. Employees then choose from the investments offered by the plan to put the money into (usually it’s mutual funds).  

The earnings on these investments are tax-free until they make withdrawals (aka distributions) upon retirement. Withdrawals are typically not possible until the employee reaches 59½ and there are tax penalties if they withdraw before then. However, there are certain exceptions to this rule, such as if it’s a hardship withdrawal. 

2. Roth 401(k) 

Sometimes called a Designated Roth Account, the Roth 401(k) is a lot like the traditional 401(k). However, this type of 401(k) has a significant difference: contributions do not get a tax break up-front, but withdrawals are tax-free if the plan holder meets certain requirements.  

As with a Roth IRA, for withdrawals to be tax- and penalty-free:  

• the plan holder must be at least 59½ years old when they make the withdrawal(s) 
• the Roth 401(k) must have been open for at least five years 

Contributions to the Roth 401(k) can be withdrawn anytime, free of tax or penalties, since these are after-tax dollars. It’s the earnings on the investments of the Roth 401(k) that are subject to tax and/or penalties if withdrawn early.  

In previous years, Roth 401(k)s were subject to the same Required Minimum Distributions (RMDs) rule as traditional 401(k)s. But in 2024, RMDs for Roth 401(k)s will be removed due to the provisions of the SECURE 2.0 Act.   

3. Safe Harbor 401(k) 

This type of 401(k) is popular with small businesses. The term Safe Harbor is a provision in tax law that exempts an individual or company from certain restrictions if they meet other requirements. In a Safe Harbor 401(k), employers can skip the nondiscrimination tests required of other 401(k) plans.  

In exchange for skipping the nondiscrimination tests, employers must contribute to every eligible employee’s plan, regardless of whether the employee contributes to the plan.  

The money in the plan is immediately vested upon the employees, regardless of how long they’ve been with the company.  

4. SIMPLE 401(k) 

This is a 401(k) plan designed for small businesses that have a maximum of 100 employees. SIMPLE stands for Savings Incentive Match PLan for Employees. Like a traditional 401(k), the money in a SIMPLE 401(k) is not subject to income taxes until it’s withdrawn upon an employee’s retirement.  

By law, employers are required to make a matching contribution to the plan equal to 3% of each employee’s salary for plan participants. They can do that or make a nonelective contribution of 2% of every employee’s salary, regardless of whether they participate in the SIMPLE plan or not.   

As with traditional 401(k), this plan has early withdrawal penalties if the plan participant is younger than 59½, and there are RMDs when the plan participant turns 73. While the SIMPLE 401(k) is more common, there are other similar 401(k) plans for small businesses.  

What happens to your 401(k) when you quit your job? 

Should an employee choose to leave their job, they have four options:

1. Withdraw all the money from the plan.  

Yes, employees can take all the money out of their 401(k) with their former employer. However, such a move is not advisable. The only time this might be a good idea is if the money is urgently needed.  

This can be the worst option since the withdrawal will become taxable in the year it was taken. What’s worse, the plan holder can also get an additional 10% tax for early withdrawal (or distribution, in IRS parlance). The only way for an employee to dodge this penalty is for them to have reached the age of 59½, have become permanently disabled, or meet other criteria for exemption set by the IRS.  

In case the plan is a Roth 401(k), the employee may withdraw their contributions (but not any of the earnings/profits) tax-free and without penalty at any time. However, the employee needs to have had the account for at least five years. It still means diminishing retirement savings, which the plan participant may regret later. 

2. Leave the 401(k) plan with the old employer.  

There are many cases where an employer would allow a departing employee to leave the 401(k) plan with them indefinitely. As amicable as this option may sound, this would mean that the employee can no longer make any contributions to the plan.  

In general, this would apply to accounts with a value of at least $5,000; but in the case of smaller amounts, the employer may require the ex-employee to take their money out.   

Leaving the money in a former employer’s 401(k) is fine if the departing employee is satisfied with the way the company handles the plan. The caveat to this is if it’s repeated often as the employee switches jobs, then they might leave a string of old 401(k) plans.  

It’s not unusual for employees to forget one or more of these plans and for their heirs to likewise be unaware of their existence. 

3. Roll over the 401(k) into an IRA. 

This option can help plan participants avoid taxes that are immediately due and preserve the account’s tax-deferred benefits. The employee can move the money to an IRA handled by a brokerage firm, a bank, or a mutual fund company. This move will also enable them to select from a wider array of investment choices and potentially obtain higher growth.  

A word of warning: the IRS has some rather stringent rules on making rollovers, and not following them can prove costly. Fortunately, the financial institution that will handle the rollover can be expected to step in and make sure the process goes smoothly.   

4. Move the old 401(k) plan to the new employer.  

Of the four options, this can be the most solid and sensible one. An employee who has left a previous employer can usually move their 401(k) balance to their new employer’s plan.  

Like the IRA rollover option, this preserves the account’s tax-deferred benefits and sidesteps taxes due immediately. This can be a wise move especially if the employee is not comfortable with making investment decisions and they prefer to let the plan administrator handle the process.  

What are the 401(k) contribution limits? 

For 2024, the 401(k) contribution limits are the same as the Roth 401(k) contribution limits. Plan participants can contribute as much as $23,000 in 2024 ($30,500 for those who are 50 years old and up). 

From what we’ve seen about the 401(k), it’s safe to say that it is one of the best investments for employees. Some financial planners would even go so far as to deem the 401(k) plan as “free money” from employers, especially when discussions revolve around the employer match.  

Due to their tax advantages, 401(k) plans can help an employee’s retirement savings grow at a rate that is much faster than investing and saving without the plan. And with the increased savings and earnings, plan holders can branch out to other IRAs and investments.  

The 401(k) is not perfect, nor is it the end-all, be-all retirement strategy for hardworking Americans.  

However, it can be one of the best retirement tools since it’s also a potential launchpad for other savings and investment opportunities.  

Find news and updates on retirement investment tools like the 401(k) right here in InvestmentNews.