A 401(k) is a tax-advantaged savings and investing plan offered by many employers, allowing employees to contribute a portion of their wages to individual accounts intended to be used during their retirement years. However, 401(k) plans are not one size fits all, as they typically come in two types: a traditional 401(k) and a Roth 401(k). Both are effective ways to save for retirement, but diverge in important details, including how they are taxed.
The two main types of 401(k) plans are traditional 401(k) plans and Roth 401(k) plans. While the retirement plans share core similarities, their differences diverge in the details.
Traditional 401(k) and Roth 401(k) plans are similar in the following ways:
The biggest difference between traditional 401(k) plans and Roth 401(k) plans is how they are taxed. Hereâ€™s how the two plans vary:
This chart quickly sums up the tax treatment of traditional 401(k) plans and Roth 401(k) plans:
|Traditional 401(k)||Roth 401(k)|
|Withdrawals||Contributions and earnings are subject to federal and most state income taxes||Contributions and earnings of qualified withdrawals are not subject to taxes|
|Best for…||Middle-aged earners who are currently in a higher tax bracket than they will likely be in the future||Younger earners who are likely in a lower tax bracket now than they will be in the future|
If your employer offers a 401(k) plan, make sure you put your contributions to work. Hereâ€™s how:
With 401(k) plans, you will have to select how much you want to contribute per paycheck â€” these are called elective deferrals. You select the percentage of income youâ€™d like withheld, and then that amount is deducted from each paycheck and deposited into your 401(k). As explained above, how those contributions are taxed will depend on whether you opt for a traditional 401(k) or a Roth 401(k). While many plans will auto-enroll you at a set contribution percentage, you should review how much you can afford to contribute to maximize any employer match and adjust accordingly.
Even the most ambitious savers are capped at how much they can contribute per year though. For both traditional 401(k) and Roth 401(k) plans, the contribution limits for 2020 are as follows:
|2020 Contribution Limits for Traditional 401(k) and Roth 401(k) Plans|
|Catch-up contribution limit||Additional $6,500|
|Joint contribution limit (employee and employer)||$57,000|
|Overall joint contribution limit (including catch-up contributions)||$63,500|
Once your contributions are deposited into your 401(k) account, you have to decide where to invest those contributions. This is a common mistake that many savers make â€” simply signing up for and contributing to your 401(k) plan is not enough. If you donâ€™t intervene, your plan might automatically keep much of your contributions in cash, where it will sit idly, as opposed to investing it in the market, where it has the potential to grow.
Many 401(k) plans offer a curated selection of mutual funds, ranging from conservative to aggressive, that you must choose from, which are managed and offered by a financial firm. After signing up for your 401(k) and selecting and making your elective deferrals, you have to choose which funds you want your contributions invested in. You can usually make these changes online after signing into your 401(k) account.
Factors to take into consideration when deciding how you to invest your contributions should include:
In many cases, you might choose from a number of prebuilt, target date portfolios. These portfolios are typically made up of diversified investments with a certain target date in mind of when you want to retire. Your portfolio is then managed to be either more aggressive or more conservative based on how far away you are from that target date.
Over time, you might change the rate of your contributions or your investment mix, but for the most part, you should sit back, relax and let your money grow untouched. In fact, even if you wanted to dip into your retirement account before your golden years, you will face heavy penalties if you do.
Typically, you cannot start making withdrawals from your 401(k) until the age of 59 Â˝. Withdrawals from your 401(k) made before this age are slapped with a tax penalty (the specifics of how those early withdrawals are taxed for both traditional and Roth 401(k) are noted above). There are certain exceptions to this rule, such as for cases of medical or financial hardship.
In addition, you canâ€™t just let your contributions sit there and grow forever. In most cases, you must start taking required minimum distributions (RMDs) from your 401(k) once you turn 72 years old.
How COVID-19 crisis impacts 401(k) plans
To help alleviate the economic damage caused by the coronavirus pandemic, the Coronavirus Aid, Relief and Economic Security (CARES) Act has made many major changes to how 401(k) plans operate in 2020 to make it easier and less expensive to access retirement funds. The main changes for 2020 include:
While you can open a number of saving and investment vehicles to grow the funds pocketed away for your golden years, 401(k) plans offer an array of special advantages: