What is a 401(k) and How to Use One in 2023?
The 401(k) is the most widely used retirement savings account for building wealth. It provides certain tax advantages that make it a key tool for retirement saving. Additionally, it provides opportunities to employ certain strategies to further enhance its potency. If you have access to a 401(k) plan, you should familiarize yourself with its capabilities in order to optimize all it has to offer.
What is a 401(k)?
A 401(k) is a type of employer-sponsored retirement plan, but not all employers offer them.
Since its inception, the 401(k) has grown into the primary tax-advantaged retirement savings vehicle of choice for most working Americans.
At the close of September 2022, there was some $6.9 Trillion in 401(k) accounts, second only to IRAs.
I’d wager most IRA money was once in a 401(k), but either way the fact remains that 401(k)s are wildly popular.
401(k)s derive their name from the section of the internal revenue code that governs their creation and operation. Other employer-sponsored plans like 403(b)s and 457s are similar but do have some unique differences.
Thrift Savings Plans (TSPs) are basically 401(k)s for government employees. Almost all the rules, benefits, and laws are the same though there are some subtle differences.
401(k) History
For decades, employers provided defined benefit plans (often called pensions, even though almost any retirement plan is technically a pension) to their employees.
Almost 60% of American workers were covered by defined benefit plans at one time. Today, that number sits between 5% and 15%.
The problem with defined benefit plans was the risk and headache they created for employers. Funding these plans was a serious ongoing challenge and a drag on profitability.
It’s no wonder companies began seeking ways to shift the responsibility for employee retirement back to the employees decades ago.
About 50 years ago some employers enacted policies to give their employees cash directly in lieu of making an employer contribution to a tax-qualified retirement account.
Congress didn’t think too highly of the practice and outlawed it in 1974.
In 1978, congress added section 401(k) to the internal revenue code to reauthorize employer contributions, but with a new legal framework designed to encourage retirement saving.
For a few years, 401(k)s were barely used until Congress further enhanced the code in 1981 allowing funding through payroll deductions.
The pension shift was on.
Within two years, nearly half of all large U.S. corporations had 401(k) plans in place or in the works.
By utilizing the 401(k), employers redirected much of the risk for managing employee retirement funds back to the employee, while still receiving tax breaks for their contributions to the plan.
In summary, America largely shifted from the defined benefit retirement plan to the defined contribution retirement plan; putting the primary responsibility for retirement saving squarely on the shoulders of the American worker.
And, if you ask me, it’s better this way because you have more control; but we’ll get into that later.
What is a 401(k)? Basic Characteristics
There are two primary characteristics that make 401(k)s attractive retirement savings vehicles.
The most beneficial characteristic is the employer match. On average, employers in the United States match up to 6% of their employees’ 401(k) contributions, dollar for dollar.
Again, 6% is an average. As we’ll discuss further below, not all 401(k) plans are created equal.
I’ve heard of plans that match up to 50% of employee contributions and others that don’t contribute at all.
Zero. Zip. Nada.
If your employer offers any sort of match, odds are it would be a wise financial decision to take it. We suggest you do just that in Milestone 2 of the Next Dollar Roadmap.
The reason you should snatch the match is because it is a guaranteed return on your investment that will likely exceed what you can gain otherwise.
On average, the S&P 500 returns 10.67% annually. A dollar-for-dollar match is an instant, 100% return.
The benefits of the employer match are obvious. Don’t miss out.
The other attractive characteristic of 401(k) plans is their tax savings advantages.
These days, most plans allow you to choose to either pay tax before you contribute and allow the account to grow tax-free (the Roth option) or defer tax on contributions until you make withdrawals in retirement (the Traditional option).
We talk more about Roth and Traditional 401(k)s below.
In either case, the tax savings basically give you the option of having Uncle Sam subsidize your retirement.
Account owners are limited on the total of tax-advantaged contributions they can make in a given year.
Furthermore, there are limitations on the combined total you and your employer can contribute, even on an after-tax basis. See the table below for these limitations.
If you are 50 years old or older, you have the option of contributing an additional $7,500 to your 401(k). This is known as a “catch-up” provision and is also available in varying amounts for HSAs, IRAs, and other retirement accounts.
2023 401(k) Contribution Limits | |
401(k) Employee Contribution | $22,500.00 |
401(k) Catch-Up Provision | $7,500.00 |
Under 50 Total 401(k) Contribution | $66,000.00 |
50 and Over Total 401(k) Contribution | $73,500.00 |
Employer contributions do not count against your annual tax-advantaged contribution limit of $22,500.
Within each plan, employees are given a variety of investment options in which to place their withheld wages.
Generally, your employer will partner with an investment company to manage the account on their behalf.
Investment companies are more than happy to manage these plans in exchange for management fees and investment expenses folded into the securities available for purchase.
It is a very lucrative business, but that doesn’t mean all plans are bad.
But not all plans are great either.
Not all plans are created equal
The basic framework of all 401(k)s is similar because the rules are set by law.
However, each employer has the freedom to choose how their plan is managed.
First, many companies are thoughtful about this and go to great lengths to provide the best possible options for their employees.
In the middle, some companies try, to the extent that the plan doesn’t create any significant administrative burden for them.
Finally, some companies award their plan management to the boss’s golfing buddy, and couldn’t seem to care less about the employees.
If the employer picks a rotten plan, the employee suffers by having fewer investment options which makes diversification challenging.
It also commonly means the investment options are saddled with unreasonably high fees which place a drag on investment returns.
Large and mega corporations typically have people whose primary job is making sure the plan is optimized for their employees.
Large plans are usually managed by large investment companies and come with sufficient investment options and reasonably low fees.
Most companies fall into the middle group.
Normally, you’ll see mid-size or fast-growing companies with plans that were set up quickly years ago, then largely ignored since.
It’s not that the company doesn’t want to do better for their employees, they may just not have anyone focused on optimizing it.
I’ve heard a lot of success stories over the years about employees who spoke up and asked for enhancements to their plans, like Roth options or a broader investment portfolio, and were successful in having the plan altered to accommodate their requests.
Often, these changes can be made at no additional cost to you or your company. Someone just has to ask.
If you’re in the third camp, my heart goes out to you. The problem here is a political one.
Don’t be afraid to ask about improving the plan, but tread lightly. You may get attention from the boss that you’d rather not have.
If you work in a place where the 401(k) plan just stinks, you might consider funding an IRA instead. In fact, if you don’t get an employer match, I’d start with an IRA.
Be sure to take advantage of any available matching because that will far outperform even very expensive investments, but an IRA will give you much more control over how your savings are invested.
401(k) Withdrawals
The primary reason Congress created the 401(k) was for retirement saving.
To persuade account owners to preserve their 401(k)s for retirement, there is a 10% penalty on any unqualified withdrawal made before the age of 59.5.
No, I don’t know why they made it 59.5 and not something logical like 60, but this is the government we’re talking about.
You can take out a loan against your 401(k), but I wouldn’t do so unless you have no other choice.
There are a few notable exceptions to the 59.5-year-old requirement.
Hardship
If you suffer a hardship (for medical expenses or you become disabled) you can make withdrawals for such expenses penalty-free.
You can also make early withdrawals for funeral expenses, college expenses, avoiding foreclosure, or repairing your home after a natural disaster, but you may still owe a penalty for these withdrawals.
Many of the rules for hardship withdrawals are set up by your employer and can vary from plan to plan.
The Rule of 55
If you retire at age 55 or later, you can begin making withdrawals from the 401(k) of the company you retire from in the year you retire.
There are some rules you need to follow carefully to avoid penalties when following this method, all of which we cover in more detail in this post.
In the linked post, we also cover IRA rollovers and rule 72(t) which allows you to begin making separate equal periodic payments (SEPP) at any age under certain conditions.
Required Minimum Distributions (RMDs)
When you turn 73, 74, or 75 (depending on when you were born), Uncle Sam is going to stop allowing your 401(k) assets to continue growing untaxed.
So, at the appropriate age, you’ll be forced to begin taking an annual required minimum distribution or RMD so the government can access their share of the tax value in your 401(k) account.
RMDs will be required whether you need the money out of your 401(k) or not, so don’t forget about them.
In the first year, RMDs are just under 4% of the total account balance and they go up from there, but you’ll never be forced to empty the account in its entirety.
There are some ways to mitigate the sting of RMDs like making qualified charitable distributions (QCDs) or converting the balance to a Roth IRA in the years preceding your RMD age to lower the account balance.
In fact, you’ll probably choose to roll your 401(k) to an IRA well before RMD age anyway for the sake of convenience. Most people do.
Historically, the IRS has forced Roth 401(k) owners to take RMDs also, even though the withdrawals aren’t taxable. They put an end to that beginning in 2024.
Traditional Vs. Roth
One of the most often contested points of view in all of finance is whether one should invest in Traditional or Roth retirement instruments.
For many years, 401(k) plans were completely pretax because the concept of an after-tax savings vehicle didn’t first appear until 1998, and even then it was for IRA accounts only.
However, in 2006 employees were given the option to begin making their contributions on an after-tax basis and the Roth 401(k) was born.
Traditional or Tax-Deferred accounts allow investors to save money in their retirement accounts without paying any income taxes on the contributions, but withdrawals are taxed at standard income tax rates.
Roth or After-Tax accounts allow investors to do the opposite. Contributions are made on an after-tax basis, but the withdrawals (including earnings) are completely tax-free.
If you want to read more about this, including a case example, follow the link above.
Want the cliff notes on deciding between the two? Here you go…
- If you think you will be in a higher tax bracket when you make withdrawals, you should use a Roth.
- If you think you will be in a lower tax bracket when you make withdrawals, you should use a Traditional account.
Now all you need is a crystal ball to know what taxes you will owe years from now and you can make the optimal choice.
If your combined marginal state and federal income tax rate is below 25%, you’re probably in good shape with the Roth.
If your combined tax rate is over 30%, you probably want to lean toward pretax.
If you’re in between, it may not matter a ton one way or the other, but personally, I lean toward Roth because income taxes are historically low while government spending continues to rise.
Uncle Sam has a lot of debt he’s going to need to pay off one day and he can either inflate his way out of it or raise the funds through higher taxes.
Odds are he’ll use some of both.
401(k) Hacks
As usual, our highly complex tax system leaves room for several creative strategies you may want to consider for your own 401(k). There is also one important pitfall to avoid.
We’ll start with the pitfall.
Don’t Outpace Your Employer
We’re all huge fans of the employer matching that is frequently available through 401(k) plans, but you need to be careful how you use them.
Typically, the earlier you can invest your money the better.
Such a mindset might tempt you to frontload your annual 401(k) contributions to the beginning of the year if you can afford to do so.
For example, let’s assume Lump Sum Larry has a $100,000 annual salary working for ABC Company which matches up to 5% of Larry’s paycheck every two weeks.
Additionally, Larry gets a $20,000 annual bonus from his employer in January and elects to put all of it into his 401(k).
The bonus only leaves $2,500 in contribution space for the rest of the year which Larry will hit somewhere in June because he’s saving 5% out of each biweekly check.
Unfortunately, ABC Company doesn’t provide a match with Larry’s bonus. Since Larry has filled up his available 401(k) contribution space in June, he’ll lose his 5% employer match for the rest of the year. Bummer.
It should be noted that many companies will adjust withholding to allow you to fully harvest your potential match, but this is not a given.
When in doubt, check with your 401(k) provider to be sure you understand how the matching is done.
The Mega Back Door Roth Method
If your 401(k) allows for in-service rollovers to an IRA, you may be able to superfund a Roth IRA using the Mega Backdoor Roth strategy.
This method calls for you to use the post-tax contribution space (up to $66,000 or $73,500 depending on your age. See the table above.) in your 401(k) to maneuver around the annual limitations for Roth IRA contributions and maximum income limits.
This is a really neat strategy, but you’ll need to be a big-time saver and have a cooperative 401(k) plan for it to work.
If you want to know more, follow the link above and get the details.
Roll it to an IRA
If you leave an employer or your employer allows in-service distributions, you can leave your 401(k) in the plan (assuming it meets certain minimum balance requirements) or you can roll it into an IRA.
The primary reason for rolling it into an IRA is you will have more flexibility in how you invest your money, leading to better diversification and perhaps a lower cost.
However, if you’re happy with the investment options in your 401(k), there’s no harm in leaving them there.
Roll an IRA to your 401(k)
You may want to roll an existing IRA into your 401(k) for a couple of reasons.
First, 401(k)s provide a higher degree of protection from litigation. All else equal, you could leave your investments here for a little legal peace of mind.
You may also want to roll your IRA into your 401(k) to avoid the pro rata rule for IRA rollovers and conversions.
The pro rata rule means the IRS views all of your IRAs as one single IRA when calculating taxes for conversions.
Suppose you want to do a backdoor Roth IRA because your income is too high to simply contribute directly to a Roth IRA, and you have an existing Traditional IRA balance of $18,000.
(You can learn more about backdoor Roth IRAs here.)
You have $6,000 available to start the backdoor process, but you’ll only be able to actually convert $1,500 of the after-tax funds into the Roth while $4,500 will come out of the pre-tax portion of your IRA.
You will owe income tax on $4,500 of the conversion, but your pretax IRA balance will be reduced by the same amount.
Furthermore $4,500 of the $6,000 in after-tax funds will remain in the IRA.
In summary: You have $24,000 as a total IRA balance. 75% of that amount is pretax and 25% is after-tax. You can only convert sums in this proportion into the Roth IRA.
For many, this totally undermines the backdoor Roth IRA strategy.
However, if you can roll your existing pretax or Traditional IRA balance into your 401(k), you’ve effectively removed the taxable portion of the conversion. Thus, clearing the way for your tax-free backdoor Roth IRA.
Net Unrealized Appreciation (NUA)
As we’ve already covered, pretax contributions and earnings to 401(k) plans are taxed as income when withdrawn from the account.
However, if you own your employer’s stock in your 401(k), you may be able to use net unrealized appreciation (NUA) to only pay capital gains taxes on the earnings.
For any given income level, capital gains taxes are always lower than income taxes. This creates a potential tax savings opportunity.
Let’s assume our friend, Lump Sum Larry, is now 60 years old and ready to retire from ABC Company. Over the years, Larry has accumulated $300,000 of ABC stock with a cost basis of $50,000.
We’ll also assume Larry is single and in the 24% income tax and 15% capital gains tax brackets.
If Larry simply rolls his 401(k) to an IRA, he’ll pay income taxes on the entire $300,000 balance as he makes withdrawals.
However, by distributing the stock into a taxable brokerage account before liquidating it, Larry would only have to pay capital gains tax on the earnings portion of the stock.
So, in his case, Larry would owe income tax on $50,000 (basis) and capital gains tax on $250,000 (earnings).
Assuming Larry realizes this income at his marginal tax rate, his overall savings would be $22,500 ($250,000 x (24% – 15%)).
Furthermore, some plans allow you to buy down your basis in the stock while it is still in the plan. In so doing, you can generate even more tax savings.
There are some tightly enforced rules about using NUA:
- You have one year to completely distribute your vested balance in your 401(k) plan and you must distribute all assets from any other qualified plans you have with your employer, even if those plans don’t have stock in them.
- You have to make the distribution to your taxable brokerage in actual shares. You cannot sell the stock within the 401(k) first, then move the funds to the brokerage account.
- You have to either completely separate service from the employer (unless you’re self-employed), be 59.5, be totally disabled, or be dead.
Tuck this one away if you have a significant amount of company stock in your 401(k). It could save you quite a bit of money one day.
Secure 2.0 Changes
In the past, the IRS has required all employer contributions to 401(k) plans to be made on a pre-tax basis.
Beginning in 2024, employees can elect to have their employer contributions made on an after-tax or Roth basis. If this route is selected, the tax liability for the contribution will be passed to the employee.
This will provide yet another avenue for fans of the Roth to stuff more savings into after-tax accounts.
A further enhancement of Secure 2.0 is automatic enrollment in company-sponsored 401(k) plans.
Beginning in 2025, new employees will automatically be enrolled in company plans, redirecting anywhere from 3% to 10% of their income into their 401(k).
This amount will steadily increase by 1% each year until it caps out at 15%.
Employees can opt out of the contribution, but this is a relatively aggressive attempt to get more people to use their 401(k).
And because Social Security is a terrible retirement plan.
Other 401(k) Nuances
If you’ve made it this far, you must really want to know a lot about 401(k)s. Here are a few final nuggets for your edification.
Highly Compensated Employees (HCEs)
The IRS restricts certain 401(k) participants from contributing the maximum amounts to their plans on a tax-deferred basis if they meet the IRS definition of a highly compensated employee.
To summarize, a fairness test is conducted and HCEs are not allowed to contribute more than two percentage points more to their 401(k) plans than non-HCEs.
So, if the average non-HCE contribution is 8% of salary, HCEs can only contribute up to 10% of their salaries.
The IRS defines an HCE as anyone who meets one of the following criteria:
- An employee whose income from the employer sponsoring the plan was $150,000 or over (in 2023);
- Anyone (or along with someone in their family) who owns more than 5% of the company sponsoring the plan.
However, if you are in the top 20% of earners at your company, your employer can also elect to classify you as an HCE.
If you are an HCE you can still contribute over the non-HCE average up to the annual maximum, but those contributions must be made on an after-tax basis.
If you over-contribute, typically the amount deposited into the plan over the fairness test limit will be refunded to you and income taxes withheld.
Safe Harbor Plans
To avoid discrimination testing, many companies elect to set up their plans as a safe harbor plan.
A safe harbor 401(k) allows employers to avoid many of the regulations and expenses that come from nondiscrimination testing required for a normal 401(k).
In order to receive this benefit, employer contributions must fully vest immediately. Additionally, employer contributions must be made in one of three forms:
Non-elective contributions – The employer must contribute at least 3% of an employee’s salary, whether the employee contributes anything or not.
Basic Matching – The employer must match 100% of an employee’s contribution up to 3% of the employee’s annual salary, and another 50% for contributions above 3% but not more than 5% of the employee’s salary.
Enhanced Matching – The employer must provide matching that is at least as generous for matching at any contribution level.
Legal Protection
We’ve alluded to the fact a couple of times now that 401(k) plans enjoy a higher level of legal protection than their IRA brothers and sisters.
Truthfully, it depends on the state, but overall your money is generally safer from creditors or lawsuits if it is in a 401(k).
The 401(k) won’t offer much protection if you owe the IRS money, though. Not much will.
FAQs:
What happens to your 401(k) when you quit or are laid off?
If you sever employment, you can leave your 401(k) where it is or roll it over to an IRA. If you elect to do a rollover, be sure to have your plan administrator send the rollover directly to your IRA custodian.
If you handle the money at any point, you could trigger a massive tax bill and penalties.
If the 401(k) balance is small, your plan administrator may liquidate the balance and send you a check unless you are proactive about moving it yourself first.
Should I use a 401(k) or put money in savings?
A 401(k) is superior to standard savings because it provides an opportunity to shield much of your savings from taxes. You only pay taxes before you contribute or when you withdraw depending on what type of account you have.
How are 401(k) withdrawals taxed?
401(k) withdrawals are taxed as regular income unless you use the NUA method we mentioned above.
Can you lose your 401(k)?
Not really. Once funds in the account are vested, they are yours.
Some plans have employment milestone requirements that leave employer funds unvested until certain periods of service are completed. If you sever employment, you will lose any unvested funds.
How much do I need in my 401(k) to retire?
That primarily depends on how much you plan to spend in retirement. For some methods for estimating the amount, see this post.
How much should I contribute to a 401(k)?
At the very least, you should contribute up to your employer match. This is free money and it’s hard to justify ignoring it.
Beyond that, the 401(k) has a lot of room (up to $73,500 annually) for retirement saving. It is a powerful vehicle for wealth building.
We suggest contributing anywhere from 15%-25% of your income to tax-advantaged retirement plans. If you have access to a solid 401(k) plan, it is a good place to start.
Other questions?
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