Table of Contents
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Table of Contents
What Is a Traditional 401(k)?
Designed by the United States Congress, the 401(k) plan was created to encourage Americans to save for retirement. A traditional 401(k) is a retirement savings and investment account offered through an employer. An employee can choose the amount they would like withdrawn out of their monthly paycheck to go into their 401(k). These contributions are invested in funds chosen by the employer and many times the employee. Any amount deposited will receive a tax break. Most employers will provide an annual “match” or set contribution as an employee benefit.
Traditional 401(k) vs. Roth IRA
Traditional 401(k)s and Roth IRAs are great ways to save for retirement. However, there are pros and cons to both.
The difference between a traditional 401(k) and a Roth (401(k) or IRA) is when you will pay taxes on the money in these accounts. With a traditional 401(k), contributions are made pre-tax. That means that your current income tax will be less. Your earnings and contributions will grow tax-deferred until withdrawal at age 59 ½. You will also be penalized for an early withdrawal (before age 59 ½).
A Roth IRA is the opposite of a traditional 401(k). Any contributions you make will be after-tax. That means that there is no tax deduction initially. Withdrawal of earnings and contributions will be tax-free at age 59 ½, assuming you’ve held the account for a minimum of five years. Early withdrawal from a Roth account (under five years) will also require you to pay a penalty fee.
Why Is a Traditional 401(k) Beneficial to Employees?
A traditional 401(k) is a great way to save for retirement. Here are three reasons why.
Reason 1: Tax-Advantaged Retirement Saving
As previously mentioned, any amount contributed to your 401(k) is pre-tax, allowing your monthly income to remain higher. When the time comes to cash out those contributions, you will likely be in a lower tax bracket which can create long-term tax savings.
Reason 2: Employer Match
Employers have the option to match a specified percentage of an employee’s contribution. This amount is typically a set portion of the total salary or, in some cases, a specific dollar amount.
Reason 3: Employee Control
A traditional 401(k) allows the employee to choose the contribution amount to be withdrawn from their income. This amount can be adjusted at any time.
Why Is a Traditional 401(k) Beneficial to Employers?
A traditional 401(k) is not only beneficial to employees, it is also beneficial to employers. Here are three reasons why.
Reason 1: Tax Benefits
According to the Internal Revenue Service (IRS), there are two tax advantages for employer sponsored plans: 1. Employers can deduct contributions on the company’s income tax return, and 2. deferrals and investment gains are not taxed.
Reason 2: Competitive Edge
Potential employees are incentivized by comprehensive benefits. Providing a 401(k) to employees gives the company an advantage over companies who do not offer this benefit.
Reason 3: Retention
Employees are more likely to engage when participating in a contribution plan. When employees invest in their future, they are less likely to move on to another company, especially if the employer contribution is significant.
Disadvantages of a Traditional 401(k)
While saving for retirement is always beneficial, there are some disadvantages to having a traditional 401(k).
Although employers typically contribute “fair” amounts, there are those who simply cannot afford it. What that means for the employee is a small match or no match at all.
Another disadvantage is the employer potentially holding the matched funds for a certain period of time. A lot of employers will choose to release those funds after the employee has been in their positions for a year or more.
In addition, early withdrawal will be heavily taxed and be subject to a 10% fee.
The employee who signs up for a 401(k) agrees to have a percentage of each paycheck paid directly into an investment account. The employer may match part or all of that contribution. The employee gets to choose among a number of investment options, usually mutual funds.
Both employees and employers are subject to contribution limits. This limit is adjusted to account for inflation. In 2022, the annual limit for employee contributions is $20,500 annually for those under the age of 50. Anyone who is age 50 or older can contribute an additional $6,500 catch-up contribution.
If the employer is contributing or if the employee chooses to make additional contributions, there is an annual cap for the employee-employer contribution amount.
Currently, for employees under the age of 50, the total employee-employer contributions cannot exceed $61,000 annually. For those who qualify for a catch-up contributions, those contributions cannot exceed $67,500.
Employers who choose to match employee contributions will use various methods for calculations. For example, an employer could choose to match .50 cents for every dollar the employee contributes.
How Does a Traditional 401(k) Earn Money?
When an employee decides to sign up for a 401(k) plan, they are able to choose where those contributions are invested from the options the employer provides. Typically, the employee can also opt for the employer to choose for them.
These options usually include stock and bond mutual funds and target-date funds, which are less risky and more secure.
The annual amount contributed, how those contributions are invested and the annual rate of return on those investments will all contribute to the speed at which the amount will grow.
Withdrawing the earnings from a traditional 401(k) will be taxed and subject to a 10% fee if the amount is withdrawn prior to age 59 ½. Since the earnings of a traditional 401(k) are tax-deferred, upon withdrawal, the money withdrawn will be taxed in the same way as regular income.
Required Minimum Distributions (RMDs)
The required minimum distributions is the amount that must be withdrawn from an employee-employer retirement plan. After reaching a certain age, traditional 401(k) account holders must comply with the required minimum distributions.
For example, after age 72, account holders who have already retired must withdraw a specific percentage. This percentage is calculated using the IRS tables based on life expectancy.
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Questions You’ve Asked Us About Traditional 401k
Michelle is a Human Resources Manager. She is dedicated to assisting employees and executives to work towards the best possible outcomes. Employee relations is what drives her career and her desire to start her own consulting firm. When she is not working on her career, she is practicing mediation and anger management techniques on children who refuse to be reasoned with.