Elements of Your 401(k)

businessman holding a 401k sign

Your 401(k) is a very important investment account. The powerful combination of tax-deferred savings, possible company match and simple investment options make it a powerful tool in planning for the future. Building a solid foundation for your 401(k) requires more than just understanding how to contribute and which investment to choose.

At Scarborough Capital Management, 401(k) plan management is one of our specialties. If you’re just getting started and are looking for the basics of how a 401(k) plan works, check out our new guide: 401(k) Plan Management. To help take your 401(k) to the next level, the financial advisors at Scarborough Capital Management offer this follow-up. 

Chapter 1

Roth Vs. Traditional

The two most common types of 401(k) plans available are Traditional 401(k)s and Roth 401(k)s.

In a Traditional 401(k), accountholders can contribute pre-tax dollars, meaning the money passes straight from your paycheck to your retirement plan, essentially bypassing Uncle Sam until later. You’ll be taxed on the money when you withdraw it in retirement. 

With a Roth 401(k), you don’t get this tax cut on contributions. Instead, you do pay taxes on the money you contribute the year of contribution, but this means you can withdraw it and the earnings, tax-free in retirement.

These tax breaks later in life are why many people contribute to a Roth IRA. However, a Roth IRA has income limits that prevent high-earners from contributing. The beauty of a Roth 401(k) is there are no such income limits; anyone can contribute, regardless of income, as long as it is available in your plan. 

When deciding between a Roth 401(k) and a Traditional 401(k), the choice generally comes down to when you want to pay taxes: Now or later. If you think you’ll be in a higher tax bracket in retirement, a Roth 401(k) may make more sense. At the same time, if you’re in a high tax bracket now, saving on present taxes with a Traditional 401(k) may be more impactful.

That said, you can also decide to contribute to both types at the same time as opposed to one or the other. In fact, having both taxable and non-taxable income in retirement can be beneficial in managing your taxes and creating a withdrawal strategy in retirement. 

The employee contribution limit for 2021 is $19,500 which includes all elective employee salary deferrals into your Traditional 401(k) and your Roth 401(k) regardless of how the contributions are split up.

Talk to a financial advisor about your options and what each looks like based on your specific situation. 

Read our blog post:

A Little 401(k) Education: Roth Versus Traditional

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Chapter 2

Roth Conversions

If you’ve already spent years saving in traditional retirement plans, you can still get the added tax advantages of a Roth in retirement by doing a Roth conversion. 

A Roth conversion is when you convert money from a traditional retirement account to a Roth retirement account. A conversion isn’t considered a distribution, so you won’t need to pay penalties if you’re under age 59-½, but you will need to pay ordinary income taxes on any amount you convert. You can convert money from a Traditional 401(k) to a Roth IRA or Roth 401(k), if your employer allows it.

The beauty of the Roth conversion is that it gives you control over when you pay taxes. You may decide to move some money from your traditional accounts to a Roth account in a year or years when you may be in a lower tax bracket. Just make sure you have the money to cover the taxes from the conversion to pay the bill the following April when you file your taxes.

Pay special attention to the five-year rule when considering a Roth conversion. The clock starts on January 1 of the year the conversion is made and you can’t withdraw them for five years without penalty.

A conversion can be a great retirement strategy, but it can also be a costly mistake. It’s a decision that is not easily undone in a Roth IRA, and cannot be reversed in a Roth 401(k). Contact the financial advisors at Scarborough Capital Management to make sure a conversion is the right move for you.

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Chapter 3

Borrowing from Your Plan

While the goal when you put money into a retirement plan is to save for, well, retirement, life sometimes gets in the way and you may find yourself needing the money sooner than expected. At times like these, a 401(k) loan may be an option.

Unlike a 401(k) withdrawal, which permanently removes money from your plan and can subject you to early withdrawal penalties, when you take a 401(k) loan, you are borrowing money from the plan with the understanding that you will pay it back – plus interest. Employers can have different rules about borrowing from your plan, but you could theoretically borrow up to 50 percent or $50,000 in a 12-month period, if your employer allows it. How long you have to repay the loan can also vary, but the maximum term allowed by the government is five years. Many plans allow these loans to be paid back faster, often with no pre-payment penalty.

Since you’ll be borrowing not withdrawing, you won’t need to pay taxes or early withdrawal penalties on the money you borrow. Repayments are made with after-tax dollars that will be taxed again when you eventually withdraw them from your account. The interest you pay on your loan goes back into your 401(k). If you miss a payment, it doesn’t impact your credit score because 401(k) loans aren’t reported to the credit bureaus. Instead, if you fail to repay your loan, it will be considered a hardship withdrawal, which means you’ll owe taxes and potentially a 10 percent penalty on the money. Not to mention you won’t have the money or any earnings you could have generated in retirement.

One of the biggest risks you run is leaving your job while you have an outstanding loan balance. Typically, you’ll be required to repay the entire balance within 90 days of your departure. If you don’t repay the remaining loan balance, it will be recharacterized as a withdrawal. Income taxes are due on the full amount and the 10 percent early withdrawal penalty may apply.

While a loan from your retirement plan is an option, it might not be the best option. Talk to the financial advisors at Scarborough Capital Management to see if this strategy is in your best interest. 

Read our blog post:

Is Borrowing from Your 401(k) a Good Idea? Financial Advisor in Annapolis Explains

Chapter 4

Understanding Your Match

One of the best ways to take advantage of your 401(k) is to ensure that you get the full company match, if your employer offers one. 

A 401(k) match is when your employer contributes to your 401(k) whenever you do, up to a certain level. It’s basically free money, so if your employer offers any level of matching, make sure you contribute at least enough to take full advantage of it, if your budget allows.

Many employers who offer a 401(k) to their employees provide some level of company match, but the rules can vary. The two most common types of company match are partial matching and dollar-for-dollar matching.

Partial matching is when your employer matches part of the money you contribute. For instance, your employer may match 50 percent of your contributions up to 6 percent of your salary. This means that for every dollar you contribute up to 6 percent of your salary, your employer will put in 50 cents. To get the full match, you’d need to contribute 6 percent of your salary. If you contribute more than 6 percent, your employer will still only match the amount up to 6 percent of your salary. That doesn’t mean you shouldn’t contribute as much as you possibly can; it just means the “free money” stops at 6 percent of your salary.

With dollar-for-dollar matching, your employer puts in as much as you do. For example, a dollar-for-dollar match up to 3 percent would mean every $1 you contribute up to 3 percent of your salary, your employer will add an additional $1. If you contribute 2 percent of your salary, your employer will contribute another 2 percent. Again, there is a cap on how much your employer will provide. If you contribute 4 percent, or 10 percent, for example, your employer will still only contribute 3 percent.

Regardless of where your employer caps its matching, aim to take full advantage of your overall contributions. At the very least, contribute whatever is necessary to get the full match, if possible. Remember, it’s free money!

 

Chapter 5

Vesting

There is one other element of company 401(k) matches that is important to know: How vesting works. 

To put it simply, vesting is the process by which you get ownership of the contributions your employer makes to your 401(k). When your employer contributes to your 401(k), that money is only yours in theory until you are fully vested. If you leave the company before a specified time, any unvested funds will stay with your employer.

The two types of vesting schedules employers can use are graded and cliff. 

With a graded vesting schedule, the percentage of the match you get to keep grows each year. For example, you may be 0 percent vested after the first year at the company, meaning that if you leave, you won’t keep any of the employer match contributions. After two years, that may increase to 20 percent vested, so you’d get to keep 20 percent of what the employer put in if you left. The vesting amount may increase by 20 percent each year, so that after year three, you’re 40 percent vested, and so on, until after six years of employment, in which you’re 100 percent vested.

With cliff vesting, you skip right from 0 percent vested to fully vested on a certain anniversary. Sometimes this is your second anniversary, but employers can require up to six years of employment to become fully vested.

Vesting applies not only to the contributions themselves but also any earnings those contributions generated. In other words, if you’re 20 percent vested when you leave your employer, you get to keep 20 percent of the match contributions plus 20 percent of the earnings the matching contributions generated while you were employed.

It’s also worth noting that vesting only applies to employer-match contributions. You have full ownership of any contributions you make to your 401(k). Whenever you leave your employer, your personal 401(k) contributions and any earnings you’ve accumulated come with you, no matter how long or how short your employment was.

Vesting can be confusing. If you have questions, contact the Scarborough Capital Management team.

 

Chapter 6

RMDs

When you turn age 72 (or if you turned 70-½ on or before January 1, 2020), you will be required to start taking Required Minimum Distributions (RMDs) from any traditional, or pre-tax, retirement accounts. Each year, the IRS requires you to withdraw a certain percentage of your traditional retirement account assets, based on your life expectancy, according to the IRS Uniform Lifetime Table. Your financial advisor can help you calculate the exact amount of your RMD each year. You’ll need to withdraw this amount – and pay ordinary income taxes on it – by December 31 of each year.

The exception to RMDs is if you are still working for your employer at age 72, in which you won’t have to take RMDs from a 401(k) at your current workplace, provided you don’t own more than 5 percent of the business.

Another way to avoid RMDs is to do a Roth IRA conversion. Roth IRAs do not have RMD requirements, but Roth 401(k)s do. In a Roth IRA, you can leave the money in the account for as long as you like – even until after you pass away, in which you can leave the money to your dependents. But remember, Roth IRA conversions also come with tax implications in the year they are converted. Again, talk to a financial advisor first to make sure this is the right decision for your situation!

This is not, and you should not consider it to be, legal or tax advice. The tax rules are complicated and their impact on a particular individual may differ depending on the individual’s specific circumstances. Neither IFG, nor SCM provide tax or legal advice. Please consult with your legal or tax advisor regarding your specific situation. Securities through Independent Financial Group, LLC (IFG), a registered broker-dealer. Member FINRA/SIPC. Advisory services offered through Scarborough Capital Management, a registered investment advisor. IFG and Scarborough Capital Management are unaffiliated entities.