Mechanics of 401(k) Plans – Saving/Contributing

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Many folks have a 401(k) plan or other similar Qualified Retirement Plan (QRP) available from their employer.  These plans have many names, including 403(b), 457, and other plans, but for clarity’s sake we’ll refer to them all as 401(k) plans in this article.  This sort of retirement savings plan can be very confusing if you’re unfamiliar, but it’s a relatively straightforward savings vehicle.

This is the first in a series of articles about the mechanics of your 401(k) plan – Saving/Contributing.

Saving/Contributing

You are allowed to make contributions to the 401(k) plan, primarily in the form of pre-tax salary deferrals.  You fill out a form (online most of the time these days) to designate a particular portion of your salary to be deferred into the 401(k) plan.  Then, each payday you’ll see a deduction from your paycheck showing the 401(k) plan contribution.  The deduction is before income tax withholding is applied to the paycheck, since these contributions are “pre-tax”.  However, Social Security and Medicare taxes are applied to these deferrals.

Because of this pre-tax nature of your deferrals into the 401(k) plan, putting money in the plan will reduce your income taxes in the year of the deferral.  For example, if your income is $30,000 per year and you defer 5% of your income into the plan, your reported taxable wages would be 5% less, or $28,500.  As a result, your possible tax bill could reduce from $2,553.75 to $2,328.75, a reduction of $225. (This is an example only, using 2013 tax tables.)

Once your money is deferred into the plan you will be eligible to invest those funds as you see fit (we’ll get to the investments in a later post).

The deferred funds are your money.  You earned it, just the same as your take-home pay. The only way you lose this money is by investing in a security that loses money, such as a stock that goes bankrupt.  Otherwise, no one can take this money away from you.  When money is deferred to the plan you have an increase to the balance in your 401(k) plan just the same as your checking account increases with the direct-deposit of your take-home pay.

Roth 401(k)

Depending on your company’s plan, you may have a Roth 401(k) component available to you.  The mechanics are similar to the garden-variety traditional 401(k) plan – except that your contributions are post-tax, rather than pre-tax.  So the changes to your tax mentioned above do not apply to contribution made to a Roth 401(k) plan.  Then, when you take the money out of the Roth 401(k) account at retirement (as long as you’re at least age 59 1/2 years of age) there is no tax on those withdrawals.  We’ll provide more detail on withdrawals in a later post.

If you have a Roth 401(k) plan available to you, it is simply another component of the overall 401(k) plan.  You have a choice as to whether or not your deferrals to the plan are made to the traditional 401(k) plan or the Roth 401(k) plan, and you can contribute any amount (up to the maximum) to the combination of these two plans in the tax year.

Annual Maximum Contributions

Each year the IRS provides guidance about the maximum annual contribution that can be made to a 401(k) plan.  For 2014, this maximum contribution is $17,500, and if the employee-participant is over age 50, an additional $5,500 “catch-up” contribution can be made for the tax year.  This could be as much as 100% of your annual contribution, if you wish.

If you are employed by more than one employer, this annual limit applies across the board to all plans that you might contribute to collectively (with one exception, below).  So if you have a second job where you can contribute to a 401(k) plan in addition to your primary job, you can only contribute up to $17,500 in total to all plans for 2014 (plus the $5,500 catch-up if over age 50).

Exception

Earlier, I mentioned that we were referring to all QRPs as 401(k) plans because they are much the same.  One difference comes about with annual contributions: 457 plans have the same limit as 401(k) plans, but are not subject to the “collective” limit mentioned above.  So if your employer provides both a 457 plan and a 403(b) plan, for instance, you could defer up to double the annual maximum contribution to these two plans – $35,000 (plus $11,000 if over age 50) for 2014.