401(k) Tax Benefits and Advantages

The 401(k) is a very popular investment vehicle for retirement planning. Participating individuals gain valuable tax advantages as they set aside a portion of their salaries to their 401(k) accounts with some getting matching contributions from their employers.

As much as $6.3 trillion was held in these plans as of September 2022. More than half of the money invested in these employer-sponsored plans was set aside in mutual funds while the rest was put into other investments.

There are many reasons why investors and retirement savers rely on their 401(k) plans. Let's take a look at the benefits and advantages of the 401(k).

What Is a 401(k)?

Named after a section of the Internal Revenue Code (IRC), 401(k)s are employer-sponsored defined-contribution plans (DC) that give workers a tax-advantaged way to save for retirement. If your employer offers a 401(k), you can opt to contribute a percentage of your income to the plan. The contributions are automatically taken out of your paycheck. If you contribute to a traditional 401(k), you can deduct them from your taxes.

Your 401(k) plan is managed by your employer, meaning they select the broker and investment options you can choose from. In contrast to an IRA, you only have a say in how much and which specific investments to contribute your money towards. With an IRA, you also select what company to hold your account.

401(k) Benefits

401(k)s offer workers a lot of benefits, including tax breaks, employer matches, high contribution limits, contribution potential at an older age, and shelter from creditors. Below, we'll take a closer look at each of these benefits.

401(k) Taxes

The tax advantages of a 401(k) begin with the fact that you make contributions on a pre-tax basis. That means you can deduct your contributions in the year you make them, which lowers your taxable income for the year. Note that this benefit applies to traditional 401(k) plans, not Roth 401(k) plans.

To compound the benefit, your 401(k) earnings accrue on a tax-deferred basis. That means the dividends and capital gains that accumulate inside your 401(k) are also not subject to tax until you begin withdrawals.

The tax treatment can be a significant benefit if you’ll be in a lower tax bracket in retirement—when you take money out—than you are when you make the contributions. This is especially true for investors currently in a high tax bracket who may receive an immediate tax benefit from the deduction of their contribution.

401(k) Match

Some employers offer to match the amount you contribute to your 401(k) plan. Some even add a profit-sharing feature that contributes a portion of the company's profits to the pot. If your company offers one or both of these features, it's heavily advised you sign up for them—they essentially represent free money with limited risk to you.

There are several types of 401(k) matches a company can choose to make. Examples include:

• A fixed percentage up to a certain amount of your earnings (i.e. a 50% match up to 6% of your salary
• A tiered percentage based on your contributions (i.e. 100% match on the first 4% of your salary, then a 50% match on the next 4% of your salary)
• A fixed percentage that relies on 401(k) contribution limits discussed below (i.e. 50% match on all contributions, up to IRS contribution limits)

For example, let's imagine a scenario with the top bullet above. Let's say you earn a $45,000 salary. If you contribute 6% of your annual earnings ($2,700) to your 401(k), your employer would contribute an additional 50% of that amount. That additional $1,350 would be added to your account, so your retirement account would have $4,050 at the end of the year ignoring any fluctuations of investment growth or loss.

401(k) Contribution Limits

You can save much more each year in a 401(k) than in an IRA. For 2022, the 401(k) contribution limit is $20,500, and the 401(k) contribution limit in 2023 is $22,500. In addition, individuals 50 years old or older are eligible to make an additional catch-up contribution. This catch-up contribution limit was an additional $6,500 in 2022 and $7,500 in 2023.

There are also limits to the total amount you and your employer can contribute to your 401(k) together. The annual addition paid into a 401(k) participant's account cannot exceed the lower of:

1. 100% of the participant's compensation or
2. $66,000 in 2023 or $61,000 in 2022

The thresholds above increase to $73,500 in 2023 and $67,500 for individuals 50 years or older that are eligible for catch-up contributions.

401(k) Contributions: Age Limit

Individuals were not able to contribute to traditional and Roth IRAs after age 70½ during the 2019 tax year. As of 2020 and beyond, the IRS states "there is no age limit on making regular contributions to traditional or Roth IRAs."

The same applies to 401(k)s. This means you can continue to contribute to these for as long you're still working. Even better, while you're working, you're spared from taking mandatory distributions from the plan, provided you own less than 5% of the business that employs you.

Shelter From Creditors

If you run into financial trouble, it's helpful to have your money in places that creditors cannot access. As it happens, 401(k)s offer excellent creditor protection. That's because these plans are set up under the Employee Retirement Income Security Act (ERISA)—and ERISA accounts are generally protected from judgment creditors.

Additionally, 401(k)s often offer some protection from federal tax liens, which are government claims against a taxpayer's assets with unpaid back taxes. The fact that 401(k) plans legally belong to your employer rather than you makes it difficult for the IRS to place a lien on the account. Depending on the language in the fine print of your account, your plan administrators may be able to refuse outright to comply with an IRS lien.

401(k) Disadvantages

Withdrawals from your traditional 401(k) are taxed at your prevailing income-tax rate when you take money out. There are restrictions on how and when you can withdraw money from the account.

Age Requirements

If you withdraw funds from a 401(k) before you reach age 59½, you'll be hit with a 10% early-withdrawal penalty fee as well as any applicable taxes.

Mandatory Withdrawals

You must begin taking required minimum distributions (RMDs) from the plan after you reach a certain age. The first distribution must be taken on April 1 the year after you turn:

• 73 if you reached that age after Jan. 1, 2023
• 72 if you reached that age between Jan. 1, 2020, and Dec. 31, 2022
• 70½ if you reached that age before Dec. 31, 2019

If you're still working, you don't have to take RMDs from the plan at your current workplace (see below for details). You will, however, need to start making withdrawals from 401(k)s at any former employers if you have any.

Limited Broker and Investment Options

You don't have a say in who to hold your 401(k) plan with but you may be able to give your employer feedback. The ultimate choice of who holds your 401(k) plan, though, lies with your employer. This means you may not have the option to avoid or defer investment fees based on who they select.

In addition, 401(k) plans often come with a limited number of investment options. Though investors can often still compile a diversified portfolio within their 401(k), they may find there are not as many options to choose from compared to other self-managed retirement accounts.

Roth 401(k)

The advantages of contributing pre-tax income to a regular 401(k) when your earnings (and tax rate) are at their peak may diminish as your career is winding down. Indeed, your income and tax rate may rise as you get older, as Social Security payments, dividends, and RMDs kick in—especially if you keep working.

Enter a different flavor of retirement account—the Roth 401(k). An ever-increasing number of companies offer Roth 401(k)s. Like its sibling, the Roth IRA, this account receives your contributions as after-tax dollars, but withdrawals are fully tax-free if you meet certain conditions.

Roth 401(k) Contribution Limits

Roth 401(k) contribution limits follow those of 401(k)s—not Roth IRAs. For 2022, an employee can contribute up to $20,500. For 2023, an employee can contribute no more than $22,500. Both of these limits are not to exceed the employee's compensation.

In addition, like a traditional 401(k), there is a limit to how much an employee and employer can contribute together to a 401(k) plan. This includes elective deferrals, employee contributions, employer matches, and discretionary contributions. The combined annual contribution may not exceed the lesser of:

1. 100% of your compensation or
2. $66,000 for 2023 or $61,000 for 2022

Again, these limits are higher for those eligible for catch-up contributions.

Roth 401(k) Income Limits

Roth 401(k)s are also an ideal avenue for high earners who want to invest in a Roth but may have their contributions to a Roth IRA limited by their income. For example, if you are a single person, you can't contribute to a Roth IRA in 2023 if your MAGI is over $153,000. Since there are no income limits for contributing to a Roth 401(k), many otherwise ineligible investors opt to receive Roth benefits through their 401(k).

The Bottom Line

It's little wonder that the 401(k) is the most popular employer-sponsored retirement plan in the nation. With the numerous 401(k) benefits, this savings plan should be part of your retirement financial portfolio, especially if your employer offers a match.

Once you're aboard with a 401(k), however, don't simply sit back and allow it to run on auto-pilot. Changes from year to year in contribution limits, tax advantages, and your financial needs make it prudent to regularly review your plan's performance and any alternatives that may suit you better.