Understanding 401K Plans in USA - CA Abhinav Gulechha

Today lets discuss about the 401k Plans which are very popular in USA and found in the investment portfolio of most of the returning NRIs coming from USA.

In the USA, there are two types of employer-based retirement plans available: defined benefit (where the money that you get on retirement is defined) or defined contribution (where the money that you invest is defined, and there is no assurance on what you get on retirement).

Over time, defined plans had become a hassle for employers to manage and now, most employers offer defined contribution plans. And amongst such category of plans, 401K is a very popular plan in the USA. Almost all of the salaried returning NRIs from the US that I’ve interacted with have an existing 401K account and are confused with what to do with their 401K money.

Today, I am going to explain more about 401K plans: features, conditions, tax breaks etc. and whether an Indian going to USA should opt for 401K, with the hope that it gives you some better idea on this investment avenue.

Basic features of 401K

Official definition of 401K as per the IRS website is as follows:

“401(k) Plan is a defined contribution plan where an employee can make contributions from his or her paycheck either before or after-tax, depending on the options offered in the plan. The contributions go into a 401(k) account, with the employee often choosing the investments based on options provided under the plan. In some plans, the employer also makes contributions such as matching the employee’s contributions up to a certain percentage. SIMPLE and safe harbor 401(k) plans have mandatory employer contributions.”

Some basic features of 401K are as follows:

It is not mandatory for employer to offer a 401K. However, most of the employers in USA do offer this plan as a retirement savings option
It is not mandatory for employee to contribute to 401K if employer offers this plan. Employee has to sign up for the plan, if he requires to be covered by it.
If employer offers a separate pension plan, one can simultaneously contribute to 401K as well as such plan. However, there are separate contribution limits that apply in such cases.
401K is basically a deferred pension plan. Whatever amount you invest, you don’t have immediate access to it, and can withdraw penalty free after age 591/2.
Loans can be availed subject to conditions
401K is creditor protected by law –this means, your creditors cannot ask the court to pay their dues using your 401K money

Contribution Limits under 401K

Both employer and employee contribution are subject to the contribution limits to 401K as follows:

Limits for employee: $23000* for 2023 (this limit is subject to revision every year). Participants who are age 50 or over can also make catch-up contributions.
Limits for employer: 100% of the participant’s compensation, or $69,000 for 2023.

Some further points on contribution limits are as follows:

In case of multiple employers, this limit will apply for all employers taken together
If your contribution exceeds the limits, it is known as “excess deferral” and you need to inform your employer before April 15 of the following year for refunding you the same.
The catch up contributions shall be subject to the actual terms & conditions of 401K plan.

Where does your 401K money go?

Important question to check, and especially since it has a bearing on the 401K corpus you’re able to create after painstakingly investing that amount year after year, is that where does that amount go, and do you as an investor have any say in that?

So, your employer who offers you the 401K generally has tie-ups with asset managers like Vanguard, Fidelity etc. and you have the choice to select the mutual funds where your 401K money will be invested.

Note that in some cases, employer contributes not in cash but in its stock – there are special rules and lower taxes applicable when you withdraw – though this may act as a temptation to hold company stock in your 401K, please note working and investing in one company gives rise to concentration risk , and I don’t think it is a very wise idea – wherever possible, invest your 401K in a diversified portfolio like a S&P 500 or a Russell 3000.

Coming back to the choice of mutual funds, note that when I say you have a choice, I also mean that you have a big responsibility to select the right mutual funds. Mutual funds can be of varied types, domestic equity (i.e. US equity), international equity, bond/fixed income, target date funds etc. – so, you MUST develop some kind of competency to first understand the risk-return equation in each fund, get a hold on your own risk tolerance and OVERALL asset allocation and then select the funds which are best suited for the long term financial goals.

The worst mistake you can do, and if you plan to stick to your 401K till 59.5 is to invest completely in US fixed income – probably when you reach your retirement, you would realise your mistake that had I invested in equity, the accumulated corpus would have been totally different.

Understand this: your time horizon is very very long (if I assume you are 30 years old, you have another 30 years to go) – and so, it makes a lot of sense to hold max. part of corpus in equity.

When I say equity, there also, I mean domestic equity i.e. USA equity – again this is with my belief that there are only 2 strong markets worth investing for a long term – USA and India (your opinion on this could be different, but I’ve seen a lot of people burn hands in investing in those exotic international and china type funds – so, to each his own)

If you need professional help on this, it is wiser to pay a small fee to a Registered Investment Adviser (RIA) in USA rather than choosing wrong funds and repenting later.

Also, speaking about US equity, there is nothing like a Vanguard S&P 500 Index – pure index with no active management and rock bottom fees. I guess similar passive options will be available with other asset managers as well, which are empanelled for your 401K – you need to ask the right questions.

Fees for 401K plans

401K plan involves certain fees. Since this fee goes on to reduce the net return from your investment, you need to pay careful attention. As per the law, the fee has to be “reasonable” and hence there is no set limits on the fees. There are following main categories of fees:

Plan Administration Fee
Investment Fee (includes sales charges, management fee & other fee)
Individual Service Fee

You can’t do much about the fees here, and I don’t think it widely differs from employer to employer. Yes, on the investment fee, if you select passive funds, you can considerably save in the long term by way of a lower investment fee.

You can read more on fees here: A Look At 401(k) Plan Fees

USA Taxation of 401K

Apart from promoting systematic deferral for long term financial goals, the second biggest attraction is the tax deduction one gets from investing in this plan.

The money you invest in the plan and the earnings on those contributions are deferred from income tax until you withdraw the money. Withdrawals are included in the taxable income however if you withdraw post your retirement, you can expect yourself to be in one of the lower tax brackets & hence the tax impact is likely to be a lot lesser.

In case you withdrawal from 401K plans before the age of 59-1/2 years, there will be two implications:

The withdrawal amount will be subject to a 10% federal penalty tax.
The withdrawal amount will be included in your income for the purpose of federal as well as state taxes.

A good resource on calculating early withdrawal penalties is a calculator by Wells Fargo Link

As regards Indian taxation of 401K for a returning NRI, I have discussed in this separate post: Taxation of 401K/IRA (USA) in India

What to do with 401K you’re changing employers:

If you change jobs, you can leave your savings invested in your current retirement plan however a better option is to roll it over to your new employer’s plan or if you are moving away from a job, moving 401K to an Individual Retirement Account i.e. IRA (something like a Vanguard IRA) or. There are no tax implications for such a rollover/ transfer. If you’re returning back to India and are winding up your US investments, there are multiple strategies you can choose to transfer your money to India, with the minimum pain.

Some tips on making the most of your 401K

Following are some tips available at the DOL website & apply generally to all defined contribution plans:

Study your employee handbook and talk to your benefits administrator to see what plan is offered and what its rules are. Read the summary plan description for specifics. Plans must follow federal law, but they can still vary widely in contribution limitations, investment options, employer matches, and other features.
Put in the maximum amount allowed.
If you can’t afford the maximum, try to contribute enough to maximize any employer matching funds.
Study carefully the menu of investment choices. Some plans offer only a few choices, others may offer hundreds. The more you know about the choices, investing, and your investment goals, the more likely you will choose wisely.
Join as soon as you become eligible.
Many companies match employee contributions with stock instead of cash. Financial experts often recommend that you don’t let your account get overloaded with company stock, particularly if the account makes up most of your retirement nest egg. Too much of a single stock increases risk.

Retirement planning options apart from 401K

Apart from 401K (or if your employer does not offer a 401K), there are other options too. You can put up to $5,500 a year into an Individual Retirement Account (IRA). Contributions to IRA are also tax efficient and operate mostly like a 401K. When you open an IRA, you have two options: a traditional IRA or a Roth IRA. The tax treatment of your contributions and withdrawals vary and will depend on which option you select.