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In 2025, the contribution limit for employees under age 50 will increase to $23,500. Employees aged 50 and above can continue to make a catch-up contribution of $7,500, bringing their total contribution limit to $31,000.
These limits are subject to annual adjustments for inflation, so it's important to stay informed about the latest contribution limits each year.
The 401(k) plan is a tax-deferred retirement savings plan where both employees and employers can contribute a portion of the employee’s salary into individual accounts. This arrangement helps workers build a retirement fund while benefiting from tax advantages.
For 2024, the Internal Revenue Service (IRS) has set the annual contribution limit at $23,000 for employees under the age of 50. Employees aged 50 and above are eligible for an additional catch-up contribution of $7,500, bringing their total contribution limit to $30,500. These limits are subject to periodic inflation adjustments.
There are three primary types of 401(k) plans:
- Traditional 401(k): Contributions are made pre-tax, reducing taxable income for the year, but withdrawals in retirement are taxed.
- Roth 401(k): Contributions are made post-tax, allowing for tax-free withdrawals in retirement.
- Simple 401(k): Designed for small businesses with simplified administration and lower contribution limits.
Investors can typically begin withdrawing from their 401(k) accounts between the ages of 59.5 and 72, with Required Minimum Distributions (RMDs) starting at age 73 for most individuals as per the SECURE Act 2.0. However, withdrawing funds before age 59.5 may result in a 10% early withdrawal penalty, along with regular income taxes on the amount withdrawn, unless specific exceptions apply. [Source: https://www.irs.gov/ | https://www.congress.gov/]
How Does the 401(k) Plan Work?
The 401(k) plan is a feature of an eligible profit-sharing scheme, allowing employees to allocate a portion of their salary to individual retirement accounts. The Internal Revenue Service (IRS) sets annual contribution limits for both employees and combined employee-employer contributions, which are subject to yearly adjustments.
Employees aged 21 years or older are generally eligible to participate in a 401(k) plan, provided they have completed at least one year of service or are not covered by a collective bargaining agreement that excludes plan participation due to negotiated retirement benefits.
For 2024, the employee elective deferral limit (applicable to traditional and safe harbor 401(k) plans) is $23,000, with an additional catch-up contribution of $7,500 for employees aged 50 and above. Contributions to Roth accounts are made post-tax, while elective salary deferrals to traditional accounts are excluded from the employee’s taxable income for the year.
To maximize the benefits of a 401(k) plan and ensure compliance, consider these four essential steps:
- Create a Written Plan: Design a comprehensive strategy detailing plan operations.
- Set Up a Trust Fund: Establish a trust to hold the plan’s assets securely.
- Develop a Recordkeeping System: Implement an approach to track contributions, earnings, and distributions accurately.
- Communicate Plan Information: Provide clear and thorough plan details to participants.
Qualified distributions from Roth accounts are tax-free, while distributions from traditional 401(k) accounts (including contributions and earnings) are taxed as part of the individual’s retirement income. Early withdrawals may incur a 10% penalty in addition to regular income taxes unless certain exceptions apply.
Types of 401(k) Plans
401(k) plan providers offer various options to suit different employee and employer needs, including Safe Harbor and Solo 401(k) plans. Below are the three most common types of 401(k) plans:
#1 - Traditional 401(k)
A traditional 401(k) plan allows employees to make contributions using pre-tax income, reducing their taxable income for the year. However, withdrawals during retirement are taxed as ordinary income. This type of plan is ideal for individuals looking to lower their current tax liability and defer taxes until retirement.
#2 - Roth 401(k)
The Roth 401(k) plan enables employees to contribute using after-tax income. The significant advantage of this plan is that qualified withdrawals, including any earnings (e.g., capital gains, dividends, or interest), are entirely tax-free. It is a suitable option for individuals who anticipate being in a higher tax bracket during retirement than they are currently.
#3 - SIMPLE 401(k) Plan
The SIMPLE (Savings Incentive Match Plan for Employees) 401(k) plan is tailored for small businesses with 100 or fewer employees earning at least $5,000 in the preceding year. Employers are required to make fully vested contributions, which means employees have immediate ownership of these funds. Unlike other plans, participants cannot receive contributions or benefit accruals from additional employer-sponsored retirement plans.
Each type of 401(k) plan has unique features designed to cater to different financial goals and organizational structures. Understanding these differences helps both employers and employees choose the plan that best aligns with their needs.
Examples
To better understand the 401(k) plan and its functionality, let’s explore some updated scenarios:
Example #1
Emily works at XYZ Corp. and opts to invest $22,500 in a Traditional 401(k) plan for the current year, contributing directly from her pre-tax income. This reduces her taxable income, allowing her to save on taxes now. However, when Emily retires and begins withdrawing from her 401(k), the distributions, including any investment gains, will be taxed as ordinary income.
Now, suppose Emily instead chooses a Roth 401(k) plan. In this case, her contributions are made from her after-tax income. While she does not receive any immediate tax benefit, her withdrawals in retirement will be entirely tax-free, provided she meets the qualifying conditions.
Example #2
John, a small business owner, establishes a SIMPLE 401(k) plan for his 10 employees, ensuring contributions are fully vested immediately. For instance, John contributes 3% of each employee's annual salary to their accounts, regardless of whether the employees make personal contributions. This type of plan encourages retirement savings while simplifying the administrative burden for John as an employer.
Example #3
A tech company, FutureTech Inc., offers a generous employer match for its 401(k) plan. For every dollar employees contribute up to 6% of their salary, the company matches 100%. For example, if Sarah, an employee earning $100,000 annually, contributes $6,000 (6% of her salary) to her 401(k), FutureTech matches her contribution dollar for dollar, adding another $6,000 to her account. This employer match effectively doubles Sarah’s contribution, significantly boosting her retirement savings.
These examples illustrate how different types of 401(k) plans work and how they benefit both employees and employers by promoting retirement savings and offering tax advantages.
401(k) Plan Withdrawal Rules
The IRS permits penalty-free withdrawals from a 401(k) plan once the account holder reaches the age of 59½. Required minimum distributions (RMDs) must commence by age 73 (effective for individuals born after December 31, 1950, per the SECURE Act 2.0). To ensure compliance and maximize retirement benefits, taxpayers are encouraged to consult with their investment manager regarding withdrawals and investment strategies.
Early withdrawals (before age 59½) generally incur a 10% penalty in addition to income taxes on the withdrawn amount. However, certain exceptions apply where this penalty is waived. For instance, withdrawals consisting of contributions on which taxes were already paid are not subject to the penalty.
A rollover is another type of untaxed withdrawal, allowing investors to transfer their 401(k) balance into another qualifying retirement account, like an IRA, without incurring penalties or taxes, provided the rollover is completed within the stipulated time frame.
The 10% penalty exists to encourage long-term participation in employer-sponsored retirement plans. However, exceptions to the early withdrawal penalty include:
- Corrective distributions
- Automatic enrollment opt-outs
- Disability
- Death of the account holder
- Domestic relations orders (such as divorce settlements)
- Employee Stock Ownership Plan (ESOP) distributions
- Substantially equal periodic payments
- Medical expenses exceeding 7.5% of adjusted gross income
- IRS levy
- Active military duty
- Separation from service after age 55 (50 for public safety employees)
- Rollovers to other qualified accounts
Frequently Asked Questions (FAQs)
1. How Do I Start a 401(k) Plan?
To initiate a 401(k) plan, follow these steps:
- Confirm eligibility and enrollment options with your employer.
- Choose between Traditional and Roth 401(k) accounts based on your tax preferences.
- Assess available investment options, such as mutual funds or target-date funds.
- Compare associated fees to optimize your returns.
- Contribute enough to maximize the employer match if offered.
- Supplement your retirement savings through additional strategies, like IRAs.
2. Can I Have Two 401(k) Plans?
Yes, you can maintain two 401(k) plans, often when transitioning between employers. For example, you may have an account with a previous employer and another with your current one. However, managing multiple plans can be complicated and may involve higher administrative costs. Consolidating accounts into a single plan or IRA may be a more efficient approach.
3. Can a Company Offer Both a 401(k) and a Profit-Sharing Plan?
Yes, companies can provide both a 401(k) and a profit-sharing plan. This combination allows employees to benefit from a structured retirement savings plan (401(k)) while also receiving additional employer contributions through profit-sharing, based on the company’s financial performance. This setup offers greater flexibility and rewards employees for the organization’s success.
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