As employers phased out traditional pensions, 401(k) plans were introduced to fill in the gaps. Named for the subsection of Internal Revenue Service code that allows for them, these accounts have become the primary retirement savings vehicle for many people.
The tax benefits of traditional 401(k) plans are important. For 2018, contributions of up to $18,500 are tax deductible. Workers age 50 and older can benefit from catch-up contributions for a total of $24,500 this year. And many employers will also match a percentage of what employees put into their plan.
While tax deductions and employer matching contributions are well-known benefits, there are other, lesser known perks of 401(k) plans, including after-tax savings options, financial resources and government protections. Keep reading to find out more lesser-known advantages.
Roth 401(k) option. When first created in 1978, 401(k) accounts had uniform provisions. All of them were funded from deductible contributions and required withdrawals in retirement to be taxed. However, in 2006, a Roth 401(k) was introduced.
This newer version of the 401(k) plan doesn’t offer deductions for contributions. After-tax money is deposited into the account, and withdrawals in retirement are then tax-free. For younger workers who see significant gains in their investments over time or workers who are in a lower tax bracket in retirement, a Roth 401(k) can mean substantial tax savings.
Similar benefits are offered through Roth IRAs, but with an important distinction. “Unlike Roth IRAs, Roth 401(k)s don’t have an income limit,” says Nick Holeman, a certified financial planner at Betterment for Business, a 401(k) administrator. What’s more, workers can contribute more to a Roth 401(k) than a Roth IRA, which caps annual contributions at $5,500 for younger workers and $6,500 for those age 50 and older.
After-tax contributions. In addition to making deductible and Roth contributions to a 401(k), workers have the option of making what are known as after-tax contributions. This ability opens up some other savings possibilities.
The first is a strategy known as a “mega backdoor” Roth. The government allows up to $55,000 in combined employee and employer contributions to a 401(k) each year for younger workers and $61,000 for those age 50 and older. Assuming someone has maxed out their tax-advantaged contributions, they could make up to $36,500 in after-tax contributions to a 401(k) depending on if and how much their employer matches. Assuming it is allowed by the employer, this after-tax money can then be transferred to a Roth IRA so that future gains can be withdrawn tax-free.
“There is only a minute percentage of Americans who are able to contribute up to $18,500 a year,” says Kevin Ta, a certified financial planner and senior wealth strategist at the financial firm PNC Wealth Management. That means the mega backdoor Roth strategy isn’t going to benefit most workers, but Ta says it’s a valuable tool for those who are able to use it.
However, after-tax contributions also show promise as a means for workers to conveniently build up nonretirement savings. For instance, Prudential recently rolled out a feature to allow workers to make automatic after-tax contributions to their 401(k) plan that can be used to build emergency savings. This money can be accessed whenever needed, and any withdrawals of the principal amount can be made without having to pay taxes or penalties.
Financial safeguards. All 401(k) plans must comply with the Employee Retirement Income Security Act, commonly called ERISA. “The benefit … is that you have a fiduciary set of standards that puts the participants’ best interests first,” says Phil Waldeck, president of the financial firm Prudential Retirement.
Plan administrators can’t push investments that maximize profits. Instead they need to ensure workers have access to stable funds with reasonable fees. They also must disclose information such as administrative expenses and historical fund performance to help employees make informed investment decisions. “It could be regarded as having the highest quality of care,” Ta says.
Another benefit of ERISA is that it protects assets from creditors. In the event a judgment is entered against a worker, assets held in qualified funds such as 401(k) accounts cannot be garnished. However, this protection does not extend to certain government garnishments such as those for federal income taxes or criminal fines.
Automatic enrollment. The convenience of 401(k) plans is an often-overlooked benefit. Not only do payroll deductions make it simple to fund retirement savings, but many companies have also set up automatic contributions for new hires.
“Auto-enrollment is very important,” Holeman says. When investing for retirement, starting early can be important to maximizing gains. However, signing up for a 401(k) plan isn’t always at the forefront of a worker’s mind when starting a new job. “It’s easy to just push this off,” Holeman says.
To keep workers from procrastinating, nearly 70 percent of large employers now auto-enroll their workers in a 401(k) plan, according to a 2017 survey of 333 companies by benefits solutions firm Alight Solutions. Nearly three-quarters of those firms will also automatically increase employee contributions over time. Though they offer a convenient way to put retirement savings on autopilot, employees can opt out of these contributions at any time.
Financial resources. Another benefit of 401(k) plans is the opportunity to obtain financial guidance. The Alight Solutions survey found 61 percent of companies offer one-on-one financial counseling and 60 percent provide online guidance.
Traditionally, this guidance has focused only on providing assistance with 401(k) investments. “It doesn’t usually branch out into how much you should be saving,” Holeman says. “We think that’s a really big missed opportunity.”
That may be changing though. “There is increasing focus on the bigger picture,” Waldeck says. A 2016 study of employee benefits by Prudential found 20 percent of surveyed companies already offer a financial wellness program and another 50 percent either plan to or would like to do so in the future. These programs may include features such as financial education and counseling.
A 401(k) plan comes with valuable tax benefits, but that isn’t the only reason to love these accounts. They can also give you the tools to make smart investment decisions, build emergency savings and more.
