February 2024 - Ferguson-Johnson Wealth Management

What Is a 401(k)?

A 401(k) is an employer-provided retirement savings plan offering tax benefits to encourage long-term investment and savings for retirement. The plans are typically included in employee benefit packages.

Benefits of a 401(k)

One of the primary benefits of a 401(k) is the tax advantages offered. With a 401(k), your savings grow either tax-deferred in a traditional account or tax-free upon withdrawal in a Roth 401(k). This setup means that dividends and capital gains within the account are not taxed, allowing for more significant investment growth.

Another key benefit of the plans is employer contributions. Many employers provide a matching contribution, often up to between 3 percent and 6 percent of an employee’s salary. This match is essentially extra compensation, rewarding employees who are proactive about their retirement savings.

How 401(k)s Work

In a 401(k) retirement plan, employees contribute a portion of their income, often with the employer matching, and funds grow with tax advantages. Traditional 401(k) plans allow for pre-tax contributions, with taxes paid upon 401(k) withdrawals in retirement. Roth 401(k) plans involve after-tax contributions, but withdrawals are tax-free.

Eligibility Criteria

Eligibility for a 401(k) typically requires contributing a percentage of your income. Employers automatically deduct this amount from your paycheck and invest it in your chosen 401(k) plan. Your contributions are pre-tax with a traditional 401(k) or after-tax with a Roth 401(k), influencing your tax situation at the time of contribution and in retirement.

Contribution Limit

The IRS sets annual 401(k) contribution limits, which can change yearly based on inflation and other factors. For 2024, the limit is $23,000 with an additional “catch-up” contribution of $7,500 for those aged 50 and over.

Vesting

Vesting in a 401(k) refers to the extent to which employer contributions are owned by the employee. While your contributions are immediately vested, employer contributions may follow a schedule, typically ranging from one to six years. The employee enrolled in the plan must remain with the company for that period to receive the funds.

Employer Enrollment Process

To enroll in a 401(k) plan, employees often go through a simple process facilitated by their employer. This involves selecting a plan that aligns with their retirement goals and risk tolerance. The plans typically offer different investment options that are generally managed by financial services advisers.

401(k) Rollovers: Changing Jobs, Handling IRAs

A 401(k) rollover is a pivotal option when changing jobs or handling an IRA. There are various rollover choices, which include:

Keeping your savings in your former employer’s 401(k) plan, provided they allow it. This option requires regular monitoring and updating of investment choices and beneficiaries to ensure alignment with your financial goals.
Transferring your old 401(k) into your new employer’s plan. This option may offer lower fees or better investment options and simplify tracking by consolidating your retirement savings.
Rolling over your old 401(k) into an Individual Retirement Account (IRA). This usually offers a broader range of investment options and potential savings on management fees, although different tax implications should be considered. You can also manage the investments of an IRA through online investment services.
Taking a lump-sum distribution (“cash-out”) directly from the 401(k) plan. This option may involve the most significant tax implications along with penalties if the participant is under age 59 ½.

In handling an IRA during a 401(k) rollover, rolling over (converting) to a traditional IRA allows tax-deferred growth with no taxes due during the transfer. Taxes are paid only upon withdrawals. Additionally, there’s an option for a Roth conversion, where if eligible you can move all or part of your old 401(k) directly into a Roth IRA.

Types of 401(k) Plans Traditional 401(k)

A Traditional 401(k) involves contributions deducted from your paycheck before income taxes, effectively reducing your current taxable income. Plans typically offer investment options, often in mutual funds, to allow savings to grow over time. Withdrawals during retirement are taxed as ordinary income. This plan is advantageous for people seeking immediate tax relief and expecting to be in a lower tax bracket during retirement.

Roth 401(k)

Compared with the traditional 401(k), Roth 401(k) contributions are made with after-tax dollars, offering no immediate tax break. However, qualified distributions, such as those after age 59½ and five years since the first contribution, are tax-free. This plan is ideal for those anticipating higher tax rates in retirement, often making it attractive for young earners at lower income levels.

Solo 401(k): Self-Employed

Designed for self-employed individuals without employees (except for a spouse), the solo 401(k) offers high contribution limits, up to $69,000 in 2024, plus a $7,500 catch-up for those over 50. It allows pre-tax contributions (traditional) or after-tax (Roth) with tax-free qualified distributions for the Roth option. A solo 401(k) is beneficial for maximizing retirement savings for business owners without full-time employees.

Investment Options

Mutual funds are a prevalent investment choice within 401(k) plans, offering a diversified mix of stocks, bonds, and other assets. These funds allow investors to pool their money together for managed investment, aligning with various investment strategies and risk profiles.

Risk Tolerance: Your risk tolerance is influenced by factors such as your age, investment goals, financial situation, and how you emotionally handle market fluctuations.
Managing Your 401(k): Effective 401(k) management involves regular and consistent contributions, rebalancing to maintain your desired asset allocation, and continuously monitoring and adjusting investments in response to changing market conditions and personal circumstances.

Withdrawals and Distributions

Early Withdrawals: Early withdrawals should be made only when necessary because of the significant financial consequences incurred, including a 10 percent penalty and taxation of the amount withdrawn as income.
Required Minimum Distributions (RMDs): Required Minimum Distributions RMDs are mandatory withdrawals that must begin from your 401(k) at a certain age, currently 73. Failing to take RMDs can result in hefty penalties.
Tax Implications: The tax implications of 401(k) contributions and withdrawals are significant aspects of retirement planning. Contributions to traditional 401(k)s are pre-tax, reducing taxable income, but withdrawals are taxed as income.

Common Mistakes to Avoid

When managing a 401(k) retirement plan, the following are some common mistakes to avoid, to optimize your retirement savings:

Neglecting Employer Match: Not fully utilizing your employer’s match is an expensive missed opportunity. Contribute enough to receive the maximum match offered by your employer, as this is essentially free money that can substantially boost your retirement savings.
Ignoring Investment Allocation: Failing to properly allocate investments within your 401(k) can impact the growth potential of your savings. Regularly review and adjust your investment choices to align with your retirement goals, risk tolerance, and investment horizon.
Not Considering the Long-Term Impact of Loans: Borrowing from your 401(k) can have a lasting negative impact. While loans from your 401(k) may seem like a quick solution for financial needs, they reduce your invested balance, potentially missing out on compound growth.

Alternatives to 401(k)s for Retirement Savings

For those seeking alternatives to 401(k) retirement savings, there are several options:

Individual Retirement Accounts (IRAs): IRAs are suitable for those without a 401(k), including the self-employed and small business owners. They offer tax advantages, varying between traditional and Roth IRAs.
SEP IRAs: Specifically for self-employed individuals and small business owners, Simplified Employee Pension Plans (SEP-IRAs) resemble traditional IRAs in terms of tax benefits and investment choices but allow for higher contribution limits.
Cash-Balance Defined-Benefit Plan: This plan is akin to a traditional pension, offering a lifetime annuity. Each employee has an individual account with a specified lump sum. For 2023, the maximum annual benefit under such a plan is $275,000.

Advantages and Disadvantages of 401(k)s Compared with Other Retirement Savings Options

Pros of a 401(k) Plan	Cons of a 401(k) Plan
You can automate contributions to a 401(k) annually, up to $23,000 in 2024, with an additional $7,500 for those 50 or older, increasing retirement savings.	Starting with smaller contributions because of other financial commitments such as loans and house purchases might hinder your ability to save enough over time.
Many employers match a portion of your contributions, adding free money to your account. For example, a 50% match up to 5% of a $60,000 salary results in an additional $1,500 from the employer.	Not all employers offer substantial matches. A smaller match, like 50% up to $500, may not significantly boost your retirement savings.
Investing in a 401(k) can be straightforward, with options like target-date funds that automatically adjust over time, simplifying retirement planning.	401(k) plans may come with management and recordkeeping fees, which can be opaque and eat into investment returns.

Employee-Established Retirement Vehicles

For business owners, retirement planning can be challenging, but don’t worry, we’ll break it down into manageable pieces.

Individual Retirement Account (IRA)

Think of an IRA as your personal retirement piggy bank. There are two main types:

Traditional IRA: With a Traditional IRA, you contribute pre-tax income and then pay taxes when you withdraw in retirement. This can be a smart move if you’re currently in a higher tax bracket.
Roth IRAs: Roth IRAs are funded with after-tax income, but the sweet deal here is that your withdrawals in retirement are tax-free.

The contribution limit for IRAs in 2024 is $7,000, or $8,000 if you’re over 50. Just remember, if you dip into this account before age 59.5, there’s a 10 percent penalty, except for special uses, such as a first-time home purchase.

Defined Contribution Plans

Imagine a defined contribution plan as a garden where you plant retirement seeds and watch them grow. With these plans, like 401(k)s, employees contribute a part of their paycheck pre-tax. Some companies match a portion of what the employee puts in—offering free money growing alongside employee contributions.

The contribution limits here are higher than those for IRAs—up to $23,000 in 2024, plus an extra $7,500 if you’re 50 or older.

Defined Benefit Plans

Also known as pension plans, defined benefit plans are like a promise from a company to pay a specific amount in retirement and are usually based on your salary and years of service. While less common now, they offer the security of knowing exactly what you’ll get when you retire.

Retirement Planning for Business Owners with an Existing Plan

If you’re a business owner with an existing retirement plan, you should stay informed about how to optimize or correct it for the benefit of your employees and your business. Below are some key points to consider.

Retirement Plan Correction Programs

Compliance mistakes happen, but the good news is there are ways to fix them. The IRS has provisions for making corrective distributions and contributions. For example, if your plan pays benefits in excess of the proper amount, you’ll need to address this either by recouping the overpayment or having the employer or a third party reimburse the plan.

Automatic Enrollment to a 401(k) Plan

Automatic enrollment can be a game changer for increasing participation in your 401(k) plan. It means employees are automatically signed up for the plan unless they opt out. This approach helps ensure that more employees are saving for retirement and also helps keep your company in line with plan testing requirements. There’s even a $500 tax incentive for businesses that include auto-enrollment provisions in their 401(k) plans, which could save your business money over time.

Retirement Income and Transition Strategies

When planning for retirement income, you should consider how you’ll transition from accumulating savings to withdrawing savings. This involves:

Strategic planning around when and how to start drawing income from your retirement accounts.
Possibly adjusting your investments as you get closer to retirement.

Tax-Efficient Withdrawal Strategies

As you transition into retirement, start thinking about how to withdraw from your retirement accounts in a tax-efficient manner. This involves:

Understanding the tax implications of withdrawing from different types of accounts (like 401(k)s, IRAs, Roth accounts, etc.).
Strategizing the order and amount of withdrawals to minimize tax liabilities.

Vesting in Employer-Sponsored Retirement Plans

Vesting in employer-sponsored retirement plans is like a loyalty program for work tenure. It determines when employees truly “own” the employer’s contributions to the retirement plan. If an employee leaves the company prior to being fully vested, some of all of the employer’s contributions to their account will return to the company.

There are a few types of vesting schedules:

Immediate Vesting: Employees are fully vested right away, meaning all the employer contributions are guaranteed to the employee from the start.
Graded Vesting: Employee ownership increases gradually over time, say 20 percent each year over five years.
Cliff Vesting: Employees have no vesting of employer contributions until a fixed length of time, such as three years, and then they become fully vested.

Matching Contributions and Advantages

Matching contributions in an employer-sponsored retirement plan, such as a 401(k), is a bit like a company offering a bonus to employees for saving for their future.

Here’s how it works: When employees contribute a portion of their salary to a retirement plan, the employer might add a matching amount. This match is often a percentage of what the employee earns in a year, up to a certain limit.

For instance, an employer might match 100 percent of employee contributions up to 3 percent of their salary and then 50 percent of the next 2 percent of compensation.

For the employee, this is a great incentive to save more. Depending on the specific provisions of the retirement plan, these matching contributions may be elective or non-elective to the employer.

Types of Small Business Retirement Plans

A. Solo 401(k)

Employee Eligibility: This plan is for self-employed individuals with no employees other than a spouse.
Contribution Limits: Regardless of company profit, you can contribute up to $23,000 in 2024, plus a $7,500 catch-up if you’re 50 or older, as the “employee” of the company. Additionally, your contributions can be made up to $69,000 (before the catch-up) using a profit calculation.
Benefit Determination: Your retirement benefit depends on your contributions and how well your investments perform.
Risk Allocation: You wear the captain’s hat here, deciding where to invest.
Vesting: It’s all yours immediately—no waiting period.

B. Defined Contribution Plans

Small Business 401(k): This plan is for businesses with employees and offers high contribution limits and optional employer matching.
Profit-Sharing Plans: Profit-sharing plans allow discretionary employer contributions with benefits based on the company’s profits.
SIMPLE-IRA: Ideal for businesses with fewer than 100 employees, these plans require employer contributions.
Safe Harbor 401(k): Similar to the standard 401(k), but this plan mandates employer contributions that are immediately vested.
403(b) Plans: Designed for employees of tax-exempt organizations, mirroring many 401(k) features.
Employee Stock Ownership Plans (ESOPs): These grant employees ownership in the company. The benefit depends on the company’s stock performance.

Frequently Asked Questions

Is it preferable to contribute to an SEP or an IRA?

Whether an SEP or an IRA is preferable depends on your specific financial situation, including factors such as your income, business size, and retirement goals. SEP IRAs often allow higher contribution limits, making them ideal for people with higher income and those looking to save more for retirement, while traditional IRAs are more straightforward and might be better for those with lower income or simpler retirement needs.

What is the difference between defined contribution and defined benefit plans?

Defined contribution plans, like 401(k)s, depend on the amount you and possibly your employer contribute and the plan’s investment performance. Your retirement benefit varies based on these factors. In contrast, defined benefit plans promise a specific retirement benefit based on factors such as salary history and years of service.

What is the significance of being 100 percent vested?

Being 100 percent vested in a retirement plan means you have full ownership of the funds in the plan, including any employer contributions. Before being fully vested, you risk losing some or all employer contributions if you leave the company.

Should one remain at a job until achieving vesting status in the employee-sponsored retirement plan?

Deciding whether to stay in a job until you’re fully vested in a retirement plan depends on your circumstances. Consider factors like your career goals, job satisfaction, and how much you stand to gain by staying until you’re fully vested.