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What is a 401(k) and How Do They Work?

Saving for retirement crosses everyone’s mind at some point in their life, and the first question you ask yourself typically is, “where do I start?” One of the most common ways to start savings is by starting a 401(k) plan with your employer! 

A 401(k) is a type of retirement plan that is directly tied to your employer. Employees can contribute a portion of pre-taxed income where it can grow tax-deferred until the time you withdraw your savings. Many companies will offer a match-incentive to their workers as well. There are many other benefits to leverage from a 401(k), but it’s important to know what are the other retirement plans available to you – let’s take a look.

Common Retirement Plans

When it comes to retirement plans, it’s crucial to understand the benefits, as well as the rules of each. For instance, if an individual has a 2020 MAGI (Modified Adjusted Gross Income) of over $139,000, they will not be able to reap the benefits of a Roth IRA (Individual Retirement Account) – Roth IRAs are only available to those that have a 2020 MAGI below $139,000. The two main items to look out for in a retirement plan are the rules around putting money in, or contribution limits, and how taking money out works, or withdrawal rules.

401(k) Plans:

Are there different types of 401(k) plans?

Yes, there are Traditional and Roth 401(k) plans. Your employer will be able to tell you which they offer, if not both.

Where can I get a 401(k) plan?

All 401(k) plans are employer-sponsored retirement plans. You may have information about this in your employee benefits package, but you can always contact the human resources department to learn more about what your company offers.

How much money can I put into my 401(k) plan?

Both types of 401(k) plans have a $19,500 annual contribution limit for 2020. These limits are never set in stone – this year’s contribution limit has grown from 2019’s which was $19,000.

The IRS also offers individuals over the age of 50 a “catch-up” option. This means they can contribute an additional $6,500 to their 401(k) for a total contribution limit of $26,000.

What are 401(k) plans benefits?

Traditional 401(k)

Contributions to traditional 401(k) plans are pre tax, which means you can reduce your annual MAGI, or in other words, you’re able to deduct your contributions from your tax bill. You will have to pay taxes on the savings, but not until you begin withdrawing funds. 

Another benefit is an employer match program – where your employer matches your contribution entirely, or a percentage of your pre-tax income, to your plan to help meet the annual contribution limit.

If your employer offers a match incentive program, and you are not taking advantage of it, you are saying no to money today, and the potential compounded returns, which can add up over time.  

Roth 401(k)

Contributions are taxed when you’re putting money in, which means your money can be grown tax-free until you withdraw your savings. Similar to traditional 401(k) plans, employers can also offer a match incentive for contributing to the retirement plan. 

When can I access money in my 401(k)?

The IRS penalizes you for taking money out too earlier. Because of that, they have created various triggers that allow an individual to take money out of their 401(k) plan penalty-free: 

  • The individual turns 59 ½ 
  • The individual has retired
  • The individual passes away or has become disabled

The IRS created Required Minimum Distributions (RMDs) rules if none of those events occur. The required date to begin RMDs is on April 1, of the following year you either reach age 72, or retire (per your plan’s rules).

What happens to my 401(k) if I change jobs?

Just because the account is held with your employer, doesn’t mean it has to stay with them if you leave – so what should you do with your 401(k) plan? There are a few options to choose from and none of them include you losing your money:

  • Leave it with your former employer
  • Roll-over your 401(k) savings into an IRA
  • Transfer the plan to your new employer
  • Withdrawal your funds or “cash out” 

IRA Plans

While planning for retirement, you will need to compare the different types of plans. Keep reading to see how an IRA might be the option for you. 

Are there different types of IRA plans?

Yes, there are four types of IRAs: Traditional IRA, Roth IRA, SEP IRA, and SIMPLE IRA. The most popular choices are traditional and Roth IRAs, which are the two we’re going to focus on. If you are looking to learn more about SEP and SIMPLE IRAs, check out our guide here.

Where can I get an IRA?

IRAs are accessible through brokerages such as TD Ameritrade, Fidelity, or Vanguard. Check out some of our top choices here for brokerages, pick one and create an IRA account – and you can begin contributing!

What IRA pros and cons?

Traditional IRA

IRA accounts have much more flexibility than 401(k) plans. Since IRA plans are managed individually, you can choose from the universe of stocks, bonds, mutual funds, ETFs and other investment vehicles.

Contributions to a traditional IRA are pre-tax, which depending on your filing status and MAGI, could qualify as a deduction to your taxable income. The negative side of that is there could be a chance that you are in a higher tax bracket when you withdraw funds, and are ultimately stuck paying more taxes. See the deduction limits for traditional IRAs below:

Filing Status2020 MAGIDeduction Amount
Single/head of household<$65,000Full
$65,001 – $74,999Partial
Married filing jointly<$104,000Full
$104,001 – $123,999Partial
Married filing jointly (spouse has plan covered by work)<$65,000Full
$65,001 – $74,999Partial
Married filing separately (you or spouse has plan covered by work)<$10,000Partial

Roth IRA

Contributions are limited to $6,000 per year, and are taxed before they hit your Roth IRA – essentially, your contributions grow tax-free. Sounds too good to be true, right? Unfortunately, to take full advantage of Roth IRA’s benefits, you must fall underneath the annual MAGI – 2020’s MAGI for a single, head of household, must fall below $124,000. 

See what your contribution limits are below:

Filing Status2020 MAGIMax. Annual Contribution 
Single/head of household<$124,000$6,000 ($7,000 if age 50+)
$124,000 – $138,999Reduced amount
>$139,000Not eligible
Married filing jointly<$196,000$6,000 ($7,000 if age 50+)
$196,000 – $205,999Reduced amount
>$206,000Not eligible
Married filing separately (and lived with spouse in the year)<$10,000

When can I access money in my IRA?

You can pull money out of your IRA whenever you please, although, if you’re younger than 59 ½, there will be an additional 10% tax for an early withdrawal penalty. If you are looking to invest your excess money but do not want to be penalized for early withdrawals, you can learn how to open a brokerage account here. 

Traditional IRA vs Roth IRA

The core difference between a traditional and Roth IRA comes down to the tax treatment of contributions. Roth IRA contributions are after-tax, and grow tax free until you begin withdrawing. 

Traditional IRA contributions are tax deferred, and depending on if you qualify, may be able to deduct contributions from your current tax bill.

Also, traditional IRA have required minimum distributions (RMDs), whereas Roth IRAs do not.

401k vs IRA Plans 

Individuals can have both a 401(k) and IRA plan, but depending on the filing status and MAGI, you may not be able to utilize both plans’ tax-advantage. 

The major difference between the two are the contribution amounts – $19,500 for 401(k) plans and $6,000 for IRAs – and who offers the plan – 401(k) plans are employer-sponsored and IRAs can be started on your own.

Since 401(k) plans are employer sponsored, investment options may be limited and rather expensive, and can be rather inflexible. Thinking glass half full, if your employer has match offerings, not taking advantage of that is essentially saying no to free money. The opposite goes for IRA accounts, as you can choose from the entire public stock, mutual fund or ETF universe for your portfolio but there are no match options available. 

How to Choose A Retirement Plan

Picking a retirement plan is not straightforward – to know which plan offers the most advantage to your financial journey, it requires you to understand how each work, and where and how they fit into your situation – if at all.

If this guide did not answer your questions, you’re not alone. We know how hard it can be to get your financial goals and savings nests in order, that’s why Investment Firms created the financial advisor matching tool to connect you with registered advisors in your area and area call away to help you answer your questions, and prepare you for retirement.