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UPDATED: Jul 15, 2021
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A 401(k) plan is a defined contribution plan offered by many employers to help employees save for their retirement, especially if your boss matches the contributions you make, since the matches are not income to you. The name 401(k) actually refers to the section of the law that governs these types of plans. These 401(k) plans are offered special treatment and have special requirements under the income tax code.
A 401k plan allows individuals to save for retirement by contributing a percentage of their pre-tax income (up to a certain amount) every year. The percentage that can be contributed is set by the IRS and may be altered annually. It may also be affected by your income and age. For example, in 2019, the general maximum amount of money that could be contributed to a 401k plan is $19,000 and, if you are 50 and over, $25,000 (this is known as the “catch up” contribution).
Money that is contributed to your 401K is taken directly from your paycheck and you do not have to pay tax on that income (hence, the ability to invest pre-tax). In many cases, your employer also “matches” your 401k contributions up to a certain percentage. For example, many employers will match up to 10 percent of the money that you contribute to your 401k. Read your plan documents.
When you contribute the money, it may be invested in a variety of different investment vehicles. Usually, mutual funds or a limited number of other investment offerings are available to you. You may select from among these investments offered by your employer and usually may move the money from one investment to another within the 401k account. You may not, however, withdraw money from your 401k prior to retirement age or you will be subject to penalties on the money that has been withdrawn.
A distribution from a company 401k plan is an annuity or a lump-sum payment. There are several options to consider should you leave your current employer and have a 401k account balance: (1) cash out (but you will be subject to federal and state taxes on the entire amount withdrawn at ordinary income rates as well as a hefty early withdrawal penalty); (2) roll the money into your new employer’s retirement plan; (3) keep the 401k money in your former employer’s plan (but you must have a vested $5,000 balance to take this option); or(4) roll the funds over into another IRA or the new employer’s retirement plan within 60 days.
There are other options if you leave your old company with an outstanding 401k loan, such as leaving the money in your fomer employer’s plan until the loan is paid. You can also let the loan go into default, but this can be a serious mistake (triggers taxes and penalties).
A traditional 401k can be converted directly to a Roth IRA or a Roth 401k. With a Roth 401K conversion, the after-tax contributions may be tax-free. A conversion from a Roth 401K to a Roth IRA could eliminate the MDR (minimum distribution requirement) because Roths do not have taxable minimum distribution requirements. You can also convert your pre-tax 401k into a Roth 401k under certain conditions; thereafter, future earnings in your Roth IRA grow tax free.
If you are confused about your 401K or about the rules governing it, you should speak with a tax attorney or with your human resources department.