A 401(k) plan is an employer-sponsored savings plan designed to help you enjoy a more financially secure retirement. If you participate in a 401(k), you put some of the money you’re earning now into a special account designed to accumulate tax-deferred earnings. When you retire, the income you withdraw from your account may make the difference between maintaining your standard of living or struggling to get by.
Traditional 401(k)s
With a traditional 401(k) you defer a percentage of your pretax income to your plan account each pay period. This amount reduces the gross salary that your employer reports to the IRS and, as a result, you owe less income tax. Both your contribution and any earnings it produces accumulate tax deferred, which means you owe no taxes on those amounts while they remain in your account. When you eventually withdraw after you retire, you pay income tax on amounts you take out at your ordinary income tax rate.
Roth 401(k)s
Employers who offer 401(k) plans may add the option of a Roth 401(k) as an alternative way to save for retirement. As the name suggests, the Roth 401(k) combines some elements of a traditional 401(k) and some elements of a Roth IRA. The income you defer to your plan account is taxable in the year you earn it rather than tax deferred. But there’s no tax due on your earnings as they accumulate, and your withdrawals are completely free of federal income tax provided you are at least 59 1/2 and your account has been open at least five years.
If your employer’s plan permits, you may be able to split your total contribution between a traditional account and a Roth account. But what you can’t do because of their different tax structures is move assets back and forth between the two versions of your employer’s plan.
401(k) distribution requirements
Traditional 401(k)s and Roth 401(k)s have the same distribution requirements, or rules for taking money out of the plans. In everyday usage, distributions are typically called withdrawals.
You typically begin taking money out of your account when you retire, and you must begin taking minimum required distributions (MRDs) no later than April 1 of the year following the year you turn 70 1/2. The only exception is that you can postpone these mandatory withdrawals as long as you continue to work, although you’re not eligible for this extension if you own 5% or more of the company where you work. Withdrawals from a traditional 401(k) are taxable at the same rate as your other income. Withdrawals from a Roth 401(k) aren’t taxable.
In most plans, you also have the alternative of rolling over the assets in your 401(k) to an IRA when you retire — traditional 401(k) assets to a traditional IRA and Roth 401(k) assets to a Roth IRA. If you choose to roll over to an IRA, the withdrawal rules depend on the type of IRA you have. With a traditional IRA, the same MRD rules apply as apply to a 401(k) and those withdrawals are taxed at your regular rate.
But if you rollover to a Roth IRA or pay the tax that’s due and convert your traditional IRA to a Roth IRA, mandatory withdrawals no longer apply. You can leave your money in the IRA as long as you wish.
