What is a Traditional 401(k)?

man_putting_coin_in_piggy_bankA Traditional 401(k) is one of several types of employer-sponsored retirement savings plans in the category of “defined contribution plans”. It is named after the section of the tax code that created it in 1978, “401(k)”. The word “traditional” has been added informally to distinguish it from the Roth 401(k), which came later.

Defined Contribution Plans (DCPs) are distinct from Defined Benefit Plans (DBPs) which came earlier and have since fallen out of popularity. DBPs were at their peak from the mid-20th century into the 1970’s and we remember them mostly as the company-specific pension plans, whereby each employer created a plan to their specifications, funded the plan as needed, controlled 100% of how the funds were invested, and paid benefits to the retired employee, and possibly their heirs, as defined by the plan. Among the disadvantages of DBPs were that employees had no control over how the funds were invested, they would likely lose all benefits upon a job change, and they could lose all benefits upon termination of employment or if the employer went out of business.

DCPs, on the other hand, require that an account be set up for each individual participant. It is most often the employee who makes contributions, though often the employer will offer some form of matching contribution when certain requirements are met. Accounts are preserved in the event of job loss, job change or the closure of the employer’s business. Account holders have some choices in the way that the money is invested within the account. Other features and benefits are discussed below.

In addition to the Traditional 401(k), there are 403(b) plans for employees of tax-exempt or non-profit organizations. There are 457 plans offered to employees of state and local municipal governments. These plans have some features in common and some features that differ. We will discuss only the Traditional 401(k) here. It is always important that you consult a tax and/or financial planning professional to know which plan is appropriate for you and your situation.

How Does a Traditional 401(k) Plan Work?

With a Traditional 401(k), your employee contribution is withdrawn from each paycheck prior to income tax witholdings and deposited into your personal 401(k) account in accordance with the parameters defined by the plan. Note that there are situations under which you may be able to contribute after-tax dollars to your account as well, and it is important to consult an independent financial advisor to know if and when this would be useful to you.

401(k) Eligibility Requirements

Eligibility requirements are defined by the employer within certain guidelines. Some will allow participation starting with the first paycheck received and some require a waiting period. Waiting periods can range from one month to a full year. Further, there may be a different waiting period established as to when employer matching contributions begin. Consult the plan’s benefit enrollment materials to learn your specific requirements.

401(k) Contribution Limits

A maximum annual contribution is set each year by the tax authorities. In 2014, the maximum contribution is set, for example, at $17,500. Employees over the age of 50 are allowed a “catch-up contribution” of an additional $5,500. The annual contribution can never exceed your annual compensation for the same year.

In practice, the amount of the contribution is usually set by the each employee to be a percentage of the portion of the salary paid during that pay period. As an example, if your salary for a given pay period is $3,000, and you set a contribution percentage of 20%, then $600 will be taken from the paycheck and automatically deposited into your 401(k) account. Terms vary from employer to employer so be sure to check the plan documentation.

Employer Matching Contributions

Employers are not required to make matching contributions. Some employers might match contributions right away and some might have a waiting period. Some may increase the amount of the matching contribution based on years of service with the company or based on their success at the companies discretion year by year.

Usually, though not always, the amount of the matching contribution is set as a percentage of the amount contributed by the employee. Let’s use the above example of a $600 employee contribution that resulted from taking 20% of a $3,000 paycheck. If the employer has defined a matching contribution of 50%, they would add an additional $300 to the employee’s account. Employer contributions also vary widely from employer to employer, with common matching percentages from 25% to 100% of the employee contribution.

Small employers may opt for a “safe harbor” plan.  Under these plans, matching is either  1) 100% for the first 4% of the employees pay contributed and 50% on the next 2% (total of 4% matched) or  2) a flat 3% for all employees regardless of any employee contribution.

Vesting Issues with a Traditional 401(k)

You are always 100% vested in the amount of your own 401(k) contributions. Vesting concerns arise with the employer-matching contributions and are set by the employer as defined in the plan. The creation of a vesting schedule over time assists the employer in the retention of quality employees. An employee is more hesitant to change jobs if they have to forfeit employer-matching contributions prior to vesting. However, some employers allow for immediate vesting and some don’t, so you must consult the 401(k) plan documentation to know the terms of your employer’s plan.

What Investment Options are Available in a Traditional 401(k)?

Available investment options can vary widely. Most plans are set up with an administrator that offers a limited number of funds to choose from. The number of options vary, with the average falling from five to fifteen funds to choose from. Some 401(k) plans permit self-directed investment options, allowing the employee to choose from a an almost unlimited set of publically traded securities akin to their own brokerage accounts.  Some plans allow for investment in the employer’s company stock.

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What Happens if I Lose my Job or Change Employers?

You generally have four options upon job loss or job change, and each must be evaluated on a case-by-case basis. It is advised to seek the advice of a tax professional or independent financial advisor before making a decision. The options are as follows:

  • If your new employer offers a 401(k) plan, you can rollover the funds from the 401(k) with your prior employer into your 401(k) account with your new employer.
  • Rollover your 401(k) account balance into a Individual Retirement Account (IRA).
  • If certain requirements are met, you can keep your 401(k) account with your prior employer.
  • You can withdraw your account balance in a lump sum cash payout. Note that this will almost certainly trigger early-withdrawal penalties, federal income taxes and possibly state income taxes.

A “rollover” is a term that indicates that the value of the account can be transferred to a different account without changing it tax status.  For example, the value can be rolled over from your 401(k) to your IRA while NOT being treated as a distribution from the plan and creating penalties or taxation.

A Quick Comparison with the Roth 401(k)

As with the Traditional IRA and Roth IRA, there is a Roth 401(k) version of the Traditional 401(k). You must check to see if your employer makes this option available. The principle difference between these two types of accounts is that the Traditional 401(k) is a tax-deferred account and the Roth 401(k) is an after-tax account. Hence, when rules are followed, contributions to a Traditional 401(k) are tax-deductible for the tax year they are made and contributions to a Roth 401(k) are not tax-deductible. The other side of this is that when withdrawals are made properly from a Traditional 401(k) in retirement, both the contributions and accumulated earnings on those contributions are taxed as ordinary income. In contrast, properly made withdrawals from a Roth 401(k) are never taxed, meaning neither the contributed portion nor the accumulated earnings on the contributed portion are taxed.

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How to Build Wealth Using Retirement Savings Accounts
The Best Retirement Savings Plans for the Self-Employed
What is a Traditional IRA?
What is a Roth 401(k)?
What is a Roth IRA?
What is the difference between Traditional and Roth 401(k)s and IRAs?
401(k) rollover options when making a job change

About the Author
Todd Frank, President & CEO, Frank Financial Advisors in San DiegoTodd E. Frank, CPA/PFS, MBA is the President and CEO of Frank Financial Advisors, a Registered Investment Advisory Firm (RIA) serving clients nationwide from our headquarters in Carlsbad, San Diego, California. As an RIA, Frank Financial Advisors is able to offer truly independent, fee-only financial advisory services.