The Rules of a 401(k) Retirement Plan

Since its inception in 1978, the 401(k) plan has grown to become the most popular type of employer-sponsored retirement plan in America. Millions of workers depend on the money they invest in these plans to provide for them in their retirement years, and many employers see a 401(k) plan as a key benefit of the job. Few other plans can match the relative flexibility of the 401(k).

What Is a 401(k) Plan?

A 401(k) plan is a retirement savings account that allows an employee to divert a portion of their salary into long-term investments. The employer may match the employee's contribution up to a limit.

A 401(k) is technically a qualified retirement plan, meaning it is eligible for special tax benefits under Internal Revenue Service (IRS) guidelines. Qualified plans come in two versions. They may be either defined contributions or defined benefits, such as a pension plan. The 401(k) plan is a defined contribution plan.

That means the available balance in the account is determined by the contributions made to the plan and the performance of the investments. The employee must make contributions to it. The employer may choose to match some portion of that contribution or not. The investment earnings in a traditional 401(k) plan are not taxed until the employee withdraws that money. This typically happens after retirement when the account balance is entirely in the hands of the employee.

The Roth 401(k) Variation

While not all employers offer it, the Roth 401(k) is an increasingly popular option. This version of a 401(k) plan requires the employee to immediately pay income tax on the contributions. However, after retirement, the money can be withdrawn with no further taxes due on either the contributions or investment earnings.

401(k) Contribution Limits

The maximum amount of salary that an employee can defer to a 401(k) plan, whether traditional or Roth, is $23,000 for 2024 and $22,500 for 2023. Employees aged 50 and older can make additional catch-up contributions of up to $7,500 for either year.

The IRS also limits the maximum joint contribution by both employer and employee. In 2023, the maximum joint contribution by both parties is $66,000 (or $73,500 for those making a catch-up contribution). In 2024, this limit is $69,000.

Contributions to a traditional 401(k) are made with pre-tax dollars and reduce the employee's taxable income, as well as their adjusted gross income (AGI). Taxes are deferred until the funds are withdrawn.

Limits for High Earners

For most people, the contribution limits on 401(k)s are high enough to allow for adequate levels of income deferral. In 2023, highly paid employees can only use the first $330,000 of income when computing maximum potential contributions. This limit increases to $345,000 in 2024.

401(k) Investment Options

A company that offers a 401(k) plan typically offers employees a choice of several investment options. The options are usually managed by a financial services advisory group such as The Vanguard Group or Fidelity Investments.

The employee can choose one or several funds to invest in. Most of the options are mutual funds, and they may include index funds, large-cap and small-cap funds, foreign funds, real estate funds, and bond funds. They usually range from aggressive growth funds to conservative income funds.

Rules for Withdrawing Money

The distribution rules for 401(k) plans differ from those that apply to individual retirement accounts (IRAs). In either case, an early withdrawal of assets from either type of plan will mean income taxes are due, and, with few exceptions, a 10% tax penalty will be levied on those younger than 59½.

But while an IRA withdrawal doesn't require a rationale, a triggering event must be satisfied to receive a payout from a 401(k) plan. The following are the usual triggering events:

• The employee retires from or leaves the job.
• The employee dies or is disabled.
• The employee reaches age 59½.
• The employee experiences a specific hardship as defined under the plan.
• The plan is terminated.

Money withdrawn from a 401(k) is usually taxed as ordinary income.

Post-Retirement Rules

Account owners who turn 73 on or after Jan. 1, 2023, must begin taking required minimum distributions (RMDs) at age 73, unless they still work for the sponsoring employer and have a plan that allows them to defer RMDs.

Before 2023, the age for RMDs was 72, after being raised from 70½ in 2019 when Congress passed the Setting Every Community Up For Retirement Enhancement (SECURE) Act.

The Rollover Option

Many retirees transfer the balance of their 401(k) plans to a traditional IRA or a Roth IRA. This rollover allows them to avoid the limited investment choices that are often present in 401(k) accounts.

If you decide to do a rollover, make sure you do it right. In a direct rollover, the money goes straight from the old account to the new account, and there are no tax implications. In an indirect rollover, the money is sent to you first, and you will owe the full income taxes on the balance in that tax year.

If your 401(k) plan has employer stock in it, you are eligible to take advantage of the net unrealized appreciation (NUA) rule and receive capital gains treatment on the earnings. That will lower your tax bill significantly.

401(k) Plan Loans

If your employer permits it, you may be able to take a loan from your 401(k) plan. If this option is allowed, up to 50% of the vested balance can be borrowed up to a limit of $50,000. The borrower must repay the loan within five years. A longer repayment period is allowed for a primary home purchase.

In most cases, the interest paid will be less than the cost of paying real interest on a bank or consumer loan—and you will be paying it to yourself. But be aware that any unpaid balance will be considered a distribution and taxed and penalized accordingly. In addition, should you leave your employer, you will be required to pay any pending 401(k) loan balance in full or face IRS tax or penalties.

Hardship Distributions

There may come a time when emergencies arise. And you may find that the only place you can turn to meet your immediate financial needs is your retirement plan. While it may not necessarily be the best route, you have the option to take hardship distributions or withdrawals. There are a number of considerations when it comes to this kind of withdrawal:

• There must be a clear and present need to take a hardship distribution. It can also be a voluntary or foreseeable need as long as it is reasonable.
• The amount of the withdrawal must not exceed the need.
• You can't take any elective distributions for six months after the hardship withdrawal.

This type of withdrawal is taxable. And if you take one of these, you aren't expected to pay it back to the account. Full details on hardship distributions are available through the IRS website.

401(k) Strategies

Every individual has a unique financial situation, and no single retirement strategy is universally best for everyone. Still, there are some broad tips or guidance that benefit most investors, especially those looking to make the most of their retirement savings.

Maximize Employer Match

One of the golden rules of retirement savings is to always try to prioritize taking the full amount of your employer match. For example, if your employer matches dollar for dollar your first 4% of 401(k) contributions, you should strive to put at least 4% into your 401(k). This strategy maximizes the free money you receive from your employer.

Be Mindful of Contribution Limits

The IRS does not permit contributions in excess of 401(k) annual limits. Should you overcontribute, you are required to then withdraw those excess contributions, triggering potential taxes and penalties. In 2023, the 401(k) contribution limit for both traditional and Roth 401(k)s was $22,500, and the contribution limit in 2024 is $23,000. There are also catch-up contributions of $7,500 for individuals 50 years or older.

Consider Roth and Traditional 401(k) Benefits

In general, it is better to contribute to Roth financial vehicles when your tax bracket is currently low and you expect to be in a higher tax bracket in the future. On the other hand, it is usually better to contribute to a traditional financial vehicle when your tax bracket is currently high. This allows you to take advantage of immediate tax benefits.

Try Not to Withdraw Early

Should you withdraw retirement plan funds early, you will be subject to Federal income tax on the withdrawal. In addition, the IRS will impose a 10% penalty on early withdrawals.Finally, withdrawing retirement savings early may stem the compounding effect your investments may experience. Leaving your 401(k) plan as-is for longer maximizes your potential for long-term portfolio growth.

The Bottom Line

Saving for retirement should be on everyone's radar, especially if you want to maintain the same lifestyle you currently have. But with so many options, where do you start? The best place is the 401(k) plan, which is offered by employers. If your company has this plan, take advantage of it. This is even more important if your employer matches contributions. But it isn't just about socking away the money that counts. Knowing the ins and outs and the rules associated with the plan can make you a better investor.