Just what is a 401(k) account, and how does it work?

UNSPLASH

Understanding the purpose of 401(k) accounts is the first step in using it to fund your retirement.

Have you ever wondered what a 401(k) is? 

It’s our retirement income consisting of contributions from your salary every pay period with a percentage matched by the employer.  It is deposited into a stock market-based account that you can access when needed throughout your life.  With the thought of not being able to pull from it until the age of 59 1/2.

Created in the 1970s, the 401(k) was a way for the employees to save for retirement that would be in theory protected from taxes. This would also allow the employee to keep the loss from their paycheck as a pension normally dropped by 50% of previous pay. This protects the standard of living from change.

A 401(k) consists of three internal accounts: two Individual Retirement Accounts and possibly a Brokerage account. One IRA is called a Roth, which is money contributed and taxed up front. The benefit is there will be no taxes taken when disbursements occur at 59 ? even on the money gained. 

With the traditional IRA, all your deposited money grows.  However, upon taking the money out for retirement you will be taxed on everything, not just the gain. However, contributions can be claimed, resulting in less taxable income. The brokerage will be treated as the traditional IRA but with potentially higher taxes. For those under 59 1/2, maximum contributions are $7,000 annually.  

How do we maximize the use of the 401(k) prior to retirement with limited taxes being inflicted? First, any early withdrawal could result in heavy fees and with a 10% tax on the withdrawal amount regardless of account, which could be higher if taken from the traditional or brokerage. 

There are ways to pull from your 401(k) without penalty and taxes.  One is to take a loan for your down payment on a home purchase or renovations, which you can pay back normally within five years.  These are not taxed because they are not withdrawals.  

Another is called a “Hardship Withdrawal” loan where there is a small amount of tax on the amount taken out.  Withdrawing funds from a Roth account in this situation results in taxation only on the earnings generated by the account. There are other loans, but they are special cases. Also, you can have only one loan at a time. Please discuss options with your finance department.

The issues with 401(k)s are the restrictions to access.  Considering the penalties and taxes, it may be best to use it for what it was created for. To build a sizable amount of money to supplement your income in retirement.  

One drawback is it was created as a supplement to your pension, which for the most part no longer exists.  Also, it’s a stock market product, so funds can affect how much you make or how much you lose. So, how do you bridge the gap and build your own bank? More on that later.

Jameson Thornton is founder of Today & Tomorrow Financial LLC in Newark, Delaware.

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