The Big List of 401k FAQs for 2020

Whether retirement is just around the corner or a couple of decades away, it’s never a bad time to plan for your retirement

401k Safe Harbor retirement planning
Learn the answers to common 401(K) questions, plus rules and regulations surrounding retirement plans

For most workers, their 401(k) retirement plan and Social Security (FICA) contributions are the financial safety net they will rely on when they reach retirement age.

Yet, the terminology used around 401(k)s can be downright confusing (DC plans, FICA, “catch up” contributions, vesting, prospectus … huh?)

We’ve compiled a list of some of the most common 401(k) questions.

What is a 401k plan?

In 1978, the Internal Revenue Service Code made it possible for U.S. workers to set aside a portion of their pre-tax income into a separate savings account called a 401(k).

In short, a 401(k) is a company-sponsored, defined contribution plan that allows employers to set aside pre-tax dollars for retirement.

Wondering what a defined contribution (DC) plan is? It’s a plan where employees set aside a fixed amount (either a dollar amount or percentage of their paycheck) for their retirement. 

These 401(k) plans were designed to encourage workers to set funds aside for their retirement by allowing them to avoid payroll taxes on the income they earned today if they saved something for the future.

Over the decades, the basic structure of 401(k) plans has changed very little. Routine updates are made to the amount employees can contribute, and some rule changes go into effect rarely, but the basics of these plans remain: employees save on payroll taxes today if they save for the future.

What is a 401k deferral?

Many employees are confused by the term 401(k) deferral. This simply means the amount of money deducted from their paycheck into their 401(k) plan. This is income deferred (or saved) for a later date.

How much can employees contribute each year?

For the plan year 2020, employee contributions are set at a maximum of $19,500 per year. The chart below outlines the IRS retirement contribution plan limits changes from 2019 to 2020.

IRS Contribution Plan Limits 401k 401(k) workest

How much do employees typically add to their 401k?

Financial advisors suggest in order to enjoy the same standard of living you had while working after you retire, employees should set aside 15% of their income into a 401(k) plan during their working years. They also recommend that the older you are when you begin saving, the higher that level should be to catch up on funding the account.

Unfortunately, on average, Americans don’t typically do so. Recent data shows that contribution levels vary by age groups. Younger workers typically have other financial pressures – paying off student loans, raising a family, or saving for the down payment of their first home.

Older workers typically contribute at higher levels as they realize retirement is more imminent. On average, those 60 to 69 years old contribute 11.2%.

On the other hand, 20 to 29 year olds on average contribute only 7%.

Does the employer contribute to employee 401k plans?

Most employers provide a matching contribution to each employee’s 401(k), even though it’s not required by law, to further incentivize workers to plan for retirement.

Businesses can match up to 100% of the employee contribution as long as the total amount funded doesn’t exceed $59,000 a year for 2020.

On average, Fidelity reports employers match about 4.7% of their employee’s contributions with additional funds into their accounts.

What are the benefits of a 401k plan for employees?

In addition to having money set aside for their retirement, employees benefit from 401(k) contributions by lowering their overall tax burden.

Every dollar set aside in a 401(k) plan is earned income that is not subject to payroll and FICA taxes.

What are the benefits of a 401k plan for employers?

The same savings in payroll and FICA contributions apply to businesses that provide a 401(k) option for staff members.

Every dollar they fund into the plan saves businesses in their overall tax burden. For 2020, the Social Security tax rate of 6.2% and Medicare tax rate of 1.45%, combined will be 7.65%.

Since employers match these amounts withheld from employee payroll, they minimally save 7.65% on every dollar an employee puts into the fund.

Additionally, if an employer matches employee contributions, any monies they contribute to the fund is considered a deductible business expense that can help reduce the company’s tax burden.

For businesses looking to start a 401(k) plan in their organization, the IRS offers a Startup Tax Credit to cover administrative and startup costs for a new plan you offer.

What is a ‘catch up’ contribution?

Some employees join plans later in their careers and hope to fund the accounts more before they hit retirement age. For workers 50 and over, an additional “catch-up contribution” is allowed. These additional funds, up to $6,500 per year, help them build up their accounts before they leave the workforce.

For businesses looking to start a 401(k) plan in their organization, the IRS offers a Startup Tax Credit to cover administrative and startup costs for a new plan you offer.

What is a vesting period?

While employees always have ownership of all the monies they contribute to their 401(k) plan, many employers have a waiting period for the amount of money the company adds to the employee account. This is a vesting period.

Typically, the longer an employee stays with the company, the more they are “vested” in the employer contribution. On average, vesting periods provide employees access to the employer portion of their fund:

  • After 1 year: 0% vested
  • After 2 years: 20% vested
  • After 3 years: 40% vested
  • After 4 years: 60% vested
  • After 5 years: 80% vested
  • After 6 years: 100% vested

This means that after 6 years, all the money funded into the account by the employer in the past and future belongs to the employee 100%.

When can employees withdraw funds from the plan?

The point of a 401(k) plan is not to withdraw funds until the employee reaches retirement age. Once a staff member reaches age 59 ½ they can begin withdrawing from the fund without incurring any penalties. Any money taken from the fund will be taxed at the current applicable rate as income.

If employees don’t take any money from the fund by age 70 ½, the IRS, in most instances, mandates Required Minimum Distributions (RMDs). This is money paid to you by your fund, based on age and life expectancy.

Are their penalties for withdrawing funds?

There are penalties for withdrawing funds from a 401(k) account before age 59 ½ with a few exceptions.

Early withdrawals can cost a 10% penalty (in addition to the taxes that must be paid on the distributed funds) unless certain conditions apply.

For the purchase of a first home, for example, employees can withdraw up to $10,000 without penalty.

For medical hardship, an IRS calculator determines the maximum withdrawal amount.

There are other exceptions to the penalty rule, as well.

How is my 401k money invested?

Most companies use a third-party provider to manage and administer their 401(k) accounts. These providers are regulated by the IRS to assure they manage employee funds in accordance with the law and in the fiduciary (financial) interests of the fund holders (employees).

Almost all providers give fund holders options on how their money will be invested. The options vary by provider, but most offer many types of investments employees can choose to direct their savings into. They run the gamut from high-risk stocks to low-risk savings accounts.

Investments in the stock market, for example, can be in new companies, green companies, Fortune 500 companies, utilities, etc. Typically the higher the risk, the higher the potential return on investment. The lower the risk, for investments like bonds or savings accounts, the lower the potential earnings.

In general, younger employees take more risk for more potential gain. Since their money will be in the fund longer, the logic is their account has more time to recover any losses. The closer an employee is to retirement age, the less risk they may want to take, so any losses will not result in a devastating effect on retirement.

Ask your 401(k) provider for a prospectus on the funds they offer. A prospectus gives you a summary of the investment approach, past performance, risk level, management fees, and a host of other information. 

What happens to a 401k when employees leave their job?

There are a few options for an employee when they leave their job.

  • Since most 401(k) plans are administered by a third-party, employees can continue to hold the account (without additional payroll contributions) until they retire
  • Employees can move their 401(k) contributions to their new employer’s plan.
  • Employees can move their investment (called a rollover) to a personal retirement plan – or IRA
  • Employees can cash out

What is 401k nondiscrimination testing?

Under the Employee Retirement Income Security Act (ERISA), employers are required to assure their 401(k) is administered in compliance with the law. To verify they are not discriminating in their plans, the federal government issues tests to confirm highly compensated employees (HCEs) and non-highly compensated employees (NHCEs) are being treated equally and in compliance with the law.

These tests compare percentages of employee and matching contributions of HCEs and NHCEs, minimum coverage tests, ownership and compensation tests, and more. The tests determine whether or not a company, or third-party administrator, is complying with the law and if any changes in the plan or its administration needs to be made.

Providing employees with the option to plan for their retirement benefits staff members and their families today and in the future. Employers who encourage and participate in retirement planning reap immediate financial benefits as well.

In addition to providing for a secure retirement, employees who know their financial needs will be met tend to be less stressed on the job, another plus for business.

If you don’t offer a 401(k) plan today, consider beginning one in the near future.

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