What is a 401(k)?
Both Americans and non-Americans who have worked for a US employer sometime in the past 30 years are likely to know a “401k plan” as simply a workplace savings and investment account, set up by an employer, and made attractive to participants through tax advantages, and sometimes matching contributions by an employer.
401k plans are named after the US Internal Revenue Code section 401, sub-section (k), which describes how the tax shelter for these plans work. The IRS also publishes additional information in IRS pub 7335, and on this page. Section 401 is only the first of several sections describing tax-deferred retirement plans: section 403(b) describes annuity plans often serving as an expensive version of a 401(k) for employees of schools and charities, 408 covers IRAs, 409 covers deferred compensation plans of for-profit companies, 457 deferred compensation for local government and non-profit employees, and a 529 is a tax-deferred college savings plan.
What are the differences between a 401(k) and an IRA?
Tax advantages of a 401k are very similar to those of an Individual Retirement Arrangement (IRA) in that you either get an up-front tax deduction on the way in, and pay tax on the way out (Traditional version), or pay the tax on the way in, and take your contributions and gains out tax free on the way out (Roth version). Either way, these accounts are sheltered from annual taxes on dividends, interest, and capital gains, making them the best place to hold high yielding stocks and bonds, or more actively managed funds that might otherwise face short-term capital gains taxes. I showed in this post how paying taxes on these gains and cash flows every year, instead of in an IRA, can make a difference of over $1,000,000 over a working career.
Other than the similar tax treatment, a 401k and IRA differ in that:
- A 401k is always set up by an employer, while an individual IRA can be set up by any individual*
- In a 401k, your investment options are limited to what your employer’s plan provides (often a list of 10-20 mutual funds), while you can invest your IRA in almost anything your custodian/broker can handle
- Contribution limits are much higher for a 401k than for an IRA: employees can contribute up to $18,500 in 2018 ($24,500 for those aged 50+), and employees can top that up to $55,000 ($61,000 for 50+), vs only $5,500 ($6,500) for an IRA
- Since technically a 401k plan is an employee benefit held in trust for you rather than an account you own, some believe there is more asset protection in a 401k from creditors and lawsuits
* SEP and SIMPLE IRAs are also set up by an employer rather than by an individual. They are far less expensive to set up and administer than a 401k, often have more flexible investment options, and have the higher $55,000 contribution limits, but do not offer the asset protection structure or employer control (over, say, vesting or unequal contributions) that a full 401k provides.
How do I set up a 401(k) plan?
An employer with US employees can set up a 401k plan with the help of a third-party administrator, a broker / custodian, an investment advisor, and often a corporate trustee. These plans often start at a few thousands US dollars per year to set up, plus a few thousand more per year for ongoing administration and compliance costs, plus another $30-300/year/employee for larger plans.
Partnerships or one-person companies can set up a significantly simpler pension for their partners or sole employee which is often known as a solo 401k or individual 401k.
When setting up a 401k plan, it is very important to choose a good investment platform, and avoid ones with expensive mutual funds.
What happens to a 401(k) after I leave or change jobs?
When you leave a job with a 401k plan, you can either a.) leave your money there in the old plan, b.) transfer your money to your new 401k plan, if your new job has one, or c.) do a direct rollover of your 401k to an IRA.
I have done option (c) with all of my own old 401k’s, and recommend clients do the same, not least because it provides us the most control over our investments in one account.
What if a 401k and IRA are not enough?
If you are in a higher tax bracket and are hitting the limits of your 401k and IRA, it may be worth looking contributing into an HSA or setting up more advanced tax shelters.