401(k) BASICS

Thinking about opening a 401(k) plan for your company?  Here are the basics that you need to know about how the plans work*:

What is a 401(k) plan?

A 401(k) plan is an employer-sponsored qualified retirement plan that offers employees the opportunity to put their own money away into the plan through payroll deductions. An employee chooses either a percentage or dollar amount that is withheld from their paycheck and then contributed into the 401(k) plan for them.

What is the maximum amount that can be contributed into the plan?

The maximum amount that anyone can contribute into the plan for calendar year 2022 is $20,500. If you are 50 years of age or older, you can put an additional $6,500 into the plan via a catch-up contribution, bringing the total contributions to $27,000.


The plan must be sponsored by a business. To be eligible, the participant must be an employee of that business and meet certain eligibility requirements:

  • MUST work at least 1 year
  • MUST work at least 1,000 hours per year (if part-time, they must average at least 20 hours per week)
  • MUST be at least 21 years of age
  • Usually, there are 2 entry dates: January 1 and July 1

All of these eligibility requirements can be modified to some degree, but these are the maximum requirements as set forth by the IRS. It could take a participant as little as 12 months and as many as 18 months to be eligible for the plan.

Why Participate?

Participating in a 401(k) plan is an opportunity for employees to save for retirement on either a tax-deferred or a tax-free basis. Social security may not cover all of an individual’s expenses in retirement; therefore, this is an opportunity for an employee to take charge of his or her own retirement.

Traditional (Pre-Tax) Contributions

A participant (employee) will receive a reduction in the amount of their taxable salary in that year, and the money inside the plan will grow tax deferred until that person takes their money out of the plan.

For example, if you make $100,000 and put 10% or $10,000 into the plan, you will only be taxed on $90,000. The other $10,000 will NOT be taxed until you take that money out of the plan. If that money grows to $100,000 and then you take it out, you will now be taxed on the FULL $100,000 – the original $10,000 that you put into the plan, plus the $90,000 of growth.

Roth 401(k) Contributions

Roth 401(k) contributions work the complete opposite of the Traditional 401(k). For example, if you make $100,000 and put 10% or $10,000 into a Roth 401(k), you will still be taxed on the full $100,000, but that $10,000 will continue to grow federally tax free. If that $10,000 grows to $100,000 and then you take it out, you will owe NO income taxes on that money – nothing on the original $10,000 (because you already paid the taxes on this money) and nothing on the $90,000 of growth.

Which contribution type should an employee consider: Traditional or Roth?

Each employee should consult their tax advisor when making this type of decision, but as a general rule, if they want to save taxes on the contributions that they make in this year, then they should consider making Traditional 401(k) contributions. If they are not really interested in getting the tax deduction this year and they don’t want to have to pay taxes at any later date on the growth of this money, then they should consider making Roth 401(k) contributions.

Leaving the Sponsoring Company – What should one do with their contributions?

There are four options for the participant:

  1. Leave it in the plan
  2. Roll it into a new 401(k) plan
  3. Roll it into an IRA
  4. Take a distribution

NOTE: The first three options have no tax consequences to them. The fourth one does. See Early Withdrawal Penalties below.

Taking Distributions in Retirement

For a Traditional 401(k), if you retire and take the money out between age 59½ and age 72, there are no penalties. However, all participants of a 401(k) plan MUST begin taking out Required Minimum Distributions (RMDs) at age 72. The same rules apply to IRAs. NOTE: Like Roth IRAs, Roth 401(k)s are NOT subject to RMDs (you’ve already paid the tax on these contributions and they grow tax free).

Early Withdrawal Penalties

If you take a distribution from your 401(k) plan prior to the age of 59½ (with some exceptions), then you will have to pay a 10% penalty on that money. This is similar to the penalty for an early withdrawal from an IRA and is mandated by the IRS. If you made Traditional 401(k) contributions, then you would also be subject to income taxes on this distribution.

*Every situtation is different, so please consult your CPA or tax professional before making any decisions with respect to your 401(k) plan.


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staff@chichesterfinancial.com   |  (602) 821-4877

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