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What Is a 401(k) and How Does It Work?

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Investopedia / Ellen Lindner


What Is a 401(k) Plan?

A 401(k) plan is a retirement savings plan offered by many American employers that has tax advantages for the saver. It is named after a section of the U.S. Internal Revenue Code (IRC).

The employee who signs up for a 401(k) agrees to have a percentage of each paycheck paid directly into an investment account. The employer may match part or all of that contribution. The employee gets to choose among a number of investment options, usually mutual funds.

Key Takeaways

  • A 401(k) plan is a company-sponsored retirement account to which employees can contribute income, while employers may match contributions.
  • There are two basic types of 401(k)s—traditional and Roth—which differ primarily in how they’re taxed.
  • With a traditional 401(k), employee contributions are pre-tax, meaning they reduce taxable income, but withdrawals are taxed.
  • Employee contributions to Roth 401(k)s are made with after-tax income: There’s no tax deduction in the contribution year, but withdrawals are tax-free.
  • Employer contributions can be made to both traditional and Roth 401(k) plans.

Introduction To The 401(K)

How 401(k) Plans Work

The 401(k) plan was designed by the United States Congress to encourage Americans to save for retirement. Among the benefits they offer is tax savings.

There are two main options, each with distinct tax advantages.

Traditional 401(k)

With a traditional 401(k), employee contributions are deducted from gross income. This means the money comes from your paycheck before income taxes have been deducted. As a result, your taxable income is reduced by the total amount of contributions for the year and can be reported as a tax deduction for that tax year. No taxes are due on either the money contributed or the investment earnings until you withdraw the money, usually in retirement.

Roth 401(k)

With a Roth 401(k), contributions are deducted from your after-tax income. This means contributions come from your pay after income taxes have been deducted. As a result, there is no tax deduction in the year of the contribution. When you withdraw the money during retirement, though, you don’t have to pay any additional taxes on your contribution or on the investment earnings.

However, not all employers offer the option of a Roth account. If the Roth is offered, you can choose between a traditional and Roth 401(k). Or you can contribute to both up to the annual contribution limit.

Contributing to a 401(k) Plan

A 401(k) is a defined contribution plan. The employee and employer can make contributions to the account up to the dollar limits set by the Internal Revenue Service (IRS).

A defined contribution plan is an alternative to the traditional pension, known as a defined-benefit plan. With a pension, the employer is committed to providing a specific amount of money to the employee for life during retirement.

In recent decades, 401(k) plans have become more common, and traditional pensions have become rare as employers have shifted the responsibility and risk of saving for retirement to their employees.

Employees also are responsible for choosing the specific investments within their 401(k) accounts from a selection that their employer offers. Those offerings typically include an assortment of stock and bond mutual funds and target-date funds designed to reduce the risk of investment losses as the employee approaches retirement.

They may also include guaranteed investment contracts (GICs) issued by insurance companies and sometimes the employer’s own stock.

Contribution Limits

The maximum amount that an employee or employer can contribute to a 401(k) plan is adjusted periodically to account for inflation, which is a metric that measures rising prices in an economy.

For 2022, the annual limit on employee contributions was $20,500 per year for workers under age 50. However, those aged 50 and over could make a $6,500 catch-up contribution.

For 2023, the annual limit on employee contributions is $22,500 per year for workers under age 50. If you are age 50 or over, you can make an additional $7,500 catch-up contribution.

If your employer also contributes or if you elect to make additional, non-deductible after-tax contributions to your traditional 401(k) account, there is a total employee-and-employer contribution amount for the year:

2022

  • For workers under 50 years old, the total employee-employer contributions could not exceed $61,000 per year.
  • If the catch-up contribution for those 50 and over was included, the limit was $67,500.

2023

  • For workers under 50 years old, the total employee-employer contributions cannot exceed $66,000 per year.
  • If the catch-up contribution for those 50 and over is included, the limit is $73,500.

Employer Matching

Employers who match employee contributions use various formulas to calculate that match.

For instance, an employer might match 50 cents for every dollar that the employee contributes, up to a certain percentage of salary.

Financial advisors often recommend that employees contribute at least enough money to their 401(k) plans to get the full employer match.

Contributing to Both a Traditional and a Roth 401(k)

If their employer offers both types of 401(k) plans, an employee can split their contributions, putting some money into a traditional 401(k) and some into a Roth 401(k).

However, their total contribution to the two types of accounts can’t exceed the limit for one account (such as $20,500 for those under age 50 in 2022 or $22,500 in 2023).

Employer contributions can be made to a traditional 401(k) account and a Roth 401(k). Withdrawals from the former will be subject to tax, whereas qualifying withdrawals from the latter are tax-free.

How Does a 401(k) Earn Money?

Your contributions to your 401(k) account are invested according to the choices you make from the selection your employer offers. As noted above, these options typically include an assortment of stock and bond mutual funds and target-date funds designed to reduce the risk of investment losses as you get closer to retirement.

How much you contribute each year, whether or not your company matches your contributions, your investments and their returns, plus the number of years you have until retirement all contribute to how quickly and how much your money will grow.

Provided you don’t remove funds from your account, you don’t have to pay taxes on investment gains, interest, or dividends until you withdraw money from the account after retirement (unless you have a Roth 401(k), in which case you don’t have to pay taxes on qualified withdrawals when you retire).

What’s more, if you open a 401(k) when you are young, it has the potential to earn more money for you, thanks to the power of compounding. The benefit of compounding is that returns generated by savings can be reinvested back into the account and begin generating returns of their own.

Over a period of many years, the compounded earnings on your 401(k) account can actually be larger than the contributions you have made to the account. In this way, as you keep contributing to your 401(k), it has the potential to grow into a sizable chunk of money over time.

Taking Withdrawals From a 401(k)

Once money goes into a 401(k), it is difficult to withdraw it without paying taxes on the withdrawal amounts.

“Make sure that you still save enough on the outside for emergencies and expenses you may have before retirement,” says Dan Stewart, CFA®, president of Revere Asset Management Inc., in Dallas. “Do not put all of your savings into your 401(k) where you cannot easily access it, if necessary.”

The earnings in a 401(k) account are tax deferred in the case of traditional 401(k)s and tax free in the case of Roths. When the traditional 401(k) owner makes withdrawals, that money (which has never been taxed) will be taxed as ordinary income. Roth account owners have already paid income tax on the money they contributed to the plan and will owe no tax on their withdrawals as long as they satisfy certain requirements.

Both traditional and Roth 401(k) owners must be at least age 59½—or meet other criteria spelled out by the IRS, such as being totally and permanently disabled—when they start to make withdrawals to avoid a penalty.

This penalty is usually an additional 10% early distribution tax on top of any other tax they owe.

Some employers allow employees to take out a loan against their contributions to a 401(k) plan. The employee is essentially borrowing from themselves. If you take out a 401(k) loan and leave the job before the loan is repaid, you’ll have to repay it in a lump sum or face the 10% penalty for an early withdrawal.

Required Minimum Distributions (RMDs)

Traditional 401(k) account holders are subject to required minimum distributions (RMDs) after reaching a certain age. (Withdrawals are often referred to as distributions in IRS parlance.)

Beginning on January 1, 2023, account owners who have retired must start taking RMDs from their 401(k) plans starting at age 73. This size of the RMD is calculated is based on your life expectancy at the time. Prior to 2020, the RMD age was 70½ years old. Before 2023, the RMD age was 72. It was updated to age 73 in the omnibus spending bill H.R. 2617 in 2022.

Note that distributions from a traditional 401(k) are taxable. Qualified withdrawals from a Roth 401(k) are not.

Roth IRAs, unlike Roth 401(k)s, are not subject to RMDs during the owner’s lifetime.

Traditional 401(k) vs. Roth 401(k)

When 401(k) plans became available in 1978, companies and their employees had just one choice: the traditional 401(k). Then in 2006, Roth 401(k)s arrived. Roths are named for former U.S. Senator William Roth of Delaware, the primary sponsor of the 1997 legislation that made the Roth IRA possible.

While Roth 401(k)s were a little slow to catch on, many employers now offer them. So the first decision employees often have to make is choosing between a Roth and a traditional (401(k).

As a general rule, employees who expect to be in a lower marginal tax bracket after they retire might want to opt for a traditional 401(k) and take advantage of the immediate tax break.

On the other hand, employees who expect to be in a higher bracket after retiring might opt for the Roth so that they can avoid taxes on their savings later. Also important—especially if the Roth has years to grow—is that, since there is no tax on withdrawals, all the money that the contributions earn over decades of being in the account is tax free.

As a practical matter, the Roth reduces your immediate spending power more than a traditional 401(k) plan. That matters if your budget is tight.

Since no one can predict what tax rates will be decades from now, neither type of 401(k) is a sure thing. For that reason, many financial advisors suggest that people hedge their bets, putting some of their money into each.

When You Leave Your Job

When you leave a company where you’ve been employed and you have a 401(k) plan, you generally have four options:

1. Withdraw the Money

Withdrawing the money is usually a bad idea unless you urgently need the cash. The money will be taxable in the year it’s withdrawn. You will be hit with the additional 10% early distribution tax unless you are over 59½, permanently disabled, or meet the other IRS criteria for an exception to the rule.

In the case of a Roth 401(k), you can withdraw your contributions (but not any profits) tax free and without penalty at any time as long as you have had the account for at least five years. Remember, however, that you’re still diminishing your retirement savings, which you may regret later.

2. Roll Your 401(k) into an IRA

By moving the money into an IRA at a brokerage firm, a mutual fund company, or a bank, you can avoid immediate taxes and maintain the account’s tax-advantaged status. What’s more, you will be able to select from among a wider range of investment choices than with your employer’s plan.

The IRS has relatively strict rules on rollovers and how they need to be accomplished, and running afoul of them is costly. Typically, the financial institution that is in line to receive the money will be more than happy to help with the process and prevent any missteps.

Funds withdrawn from your 401(k) must be rolled over to another retirement account within 60 days to avoid taxes and penalties.

3. Leave Your 401(k) With the Old Employer

In many cases, employers will permit a departing employee to keep a 401(k) account in their old plan indefinitely, though the employee can’t make any further contributions to it. This generally applies to accounts worth at least $5,000. In the case of smaller accounts, the employer may give the employee no choice but to move the money elsewhere.

Leaving 401(k) money where it is can make sense if the old employer’s plan is well managed and you are satisfied with the investment choices it offers. The danger is that employees who change jobs over the course of their careers can leave a trail of old 401(k) plans and may forget about one or more of them. Their heirs might also be unaware of the existence of the accounts.

4. Move Your 401(k) to a New Employer

You can usually move your 401(k) balance to your new employer’s plan. As with an IRA rollover, this maintains the account’s tax-deferred status and avoids immediate taxes.

It could be a wise move if you aren’t comfortable with making the investment decisions involved in managing a rollover IRA and would rather leave some of that work to the new plan’s administrator.

How Do You Start a 401(k)?

The simplest way to start a 401(k) plan is through your employer. Many companies offer 401(k) plans and some will match part of an employee’s contributions. In this case, your 401(k) paperwork and payments will be handled by the company during onboarding.

If you are self-employed or run a small business with your spouse, you may be eligible for a solo 401(k) plan, also known as an independent 401(k). These retirement plans allow freelancers and independent contractors to fund their own retirement, even though they are not employed by another company. A solo 401(k) can be created through most online brokers.

What Is the Maximum Contribution to a 401(k)?

For most people, the maximum contribution to a 401(k) plan is $20,500 in 2022 and $22,500 in 2023. If you are more than 50 years old, you can make an additional 2022 catch-up contribution of $6,500 for a total of $27,000 (the catch-up contribution for 2023 is $7,500 for a total of $30,000). There are also limitations on the employer’s matching contribution: The combined employer-employee contributions cannot exceed $61,000 in 2022 (or $67,500 for employees over 50 years old) and $66,000 in 2023 (or $73,500 for employees over 50 years old).

Is It a Good Idea to Take Early Withdrawals from Your 401(k)?

There are few advantages to taking an early withdrawal from a 401(k) plan. If you take withdrawals before age 59½, you will face a 10% penalty in addition to any taxes you owe. However, some employers allow hardship withdrawals for sudden financial needs, such as medical costs, funeral costs, or buying a home. This can help you avoid the early withdrawal penalty but you will still have to pay taxes on the withdrawal.

What Is the Main Benefit of a 401(k)?

A 401(k) plan lets you reduce your tax burden while saving for retirement. Not only do you get tax-deferred gains but it’s also hassle-free since contributions are automatically subtracted from your paycheck. In addition, many employers will match part of their employee’s 401(k) contributions, effectively giving them a free boost to their retirement savings.

The Bottom Line

A 401(k) plan is a workplace retirement plan that lets you make annual contributions up to a certain limit and invest that money for the benefit of your later years once your working days are done.

401(k) plans come in two types: a traditional or Roth. The traditional 401(k) involves pre-tax contributions that give you a tax break when you make them and reduce your taxable income. However, you pay ordinary income tax on your withdrawals. The Roth 401(k) involves after-tax contributions and no upfront tax break, but you’ll pay no taxes on your withdrawals in retirement. Both accounts allow employer contributions that can increase your savings.

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403(b) Plan: What It Is, How It Works, 2 Main Types

Written by admin. Posted in #, Financial Terms Dictionary

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What Is a 403(b) Plan?

The term 403(b) plan refers to a retirement account designed for certain employees of public schools and other tax-exempt organizations. Participants may include teachers, school administrators, professors, government employees, nurses, doctors, and librarians.

The 403(b) plan, which is closely related to the better-known 401(k) plan, allows participants to save money for retirement through payroll deductions while enjoying certain tax benefits. There’s also an option for the employer to match part of the employee’s contribution.

Key Takeaways

  • 403(b)s are retirement savings plans that serve employees of public schools and tax-exempt organizations.
  • Contributions to 403(b) plans are made through payroll deductions.
  • The IRS limits the amount that employees can contribute to their 403(b) plans.
  • The advantages of a 403(b) include faster vesting of funds and the ability to make additional catch-up contributions.
  • Investment choices may be more limited with a 403(b) and some accounts offer less protection from creditors than 401(k)s.

How 403(b) Plans Work

As noted above, individuals employed by schools and other tax-exempt organizations can save for retirement by contributing to a 403(b) plan through payroll deductions. The plan is akin to the 401(k) plan used by private-sector employees. Participants can include:

  • Employees of public schools, state colleges, and universities
  • Public school employees of Indian tribal governments
  • Church employees
  • Employees of tax-exempt 501(c)(3) organizations
  • Ministers and clergy members

The 403(b) plan has the same caps on yearly contributions that come with 401(k) plans. The maximum contributions allowed are $20,500 and $22,500 for the 2022 and 2023 tax years respectively. For 2022, he plan also offers $6,500 catch-up contributions for those age 50 and older, increasing to $7,500 for 2023. Combined employee and employer contributions are limited to the lesser of $61,000 in 2022 and $66,000 in 2023 or 100% of the employee’s most recent yearly salary.

Participants must reach age 59½ before withdrawing funds or get slapped with an early withdrawal penalty. 

If your employer offers a 403(b) and a 401(k) you can contribute to both but your aggregate contribution cannot be more than the annual limit ($20,500 in 2022 and $22,500 in 2023)—not counting any catch-up contributions.

Special Considerations

Although it is not very common, your job situation could end up giving you access to both a 401(k) and a 403(b) plan. Each offers employees a tax-advantaged way to save for retirement, but investment choices are often more limited in a 403(b) plan than a 401(k). And remember, 401(k)s serve private-sector employees.

But unlike a 401(k), the 403(b) plan also offers a special plan for those with 15 or more years of service with the same employer (see below).

Types of 403(b) Plans

There are generally two broad types of 403(b) plan—the traditional and the Roth. Not all employers allow employees access to the Roth version.

A traditional 403(b) plan allows the employee to have pretax money automatically deducted from each paycheck and paid into a personal retirement account. The employee has put away some money for the future and at the same time reduced his or her gross income (and income taxes owed for the year). The taxes will be due on that money only when the employee withdraws it.

A Roth 403(b) requires that after-tax money be paid into the retirement account. There’s no immediate tax advantage. But the employee will not owe any more taxes on that money or the profit it accrues when it is withdrawn.

Clergy can also participate in a 403(b) but there’s a special plan type—a 403(b)(9)—that’s designed specifically for employees of religious institutions.

Advantages and Disadvantages of 403(b) Plans

There are distinct benefits and drawbacks of holding a 403(b) plan. We’ve highlighted some of the most common ones below.

Advantages

Earnings and returns on amounts in a regular 403(b) plan are tax-deferred until they are withdrawn. Earnings and returns on amounts in a Roth 403(b) are tax-deferred if the withdrawals are qualified distributions.

Certain 403(b) plans are not required to meet the onerous oversight rules of the Employee Retirement Income Security Act (ERISA). As such, these plans tend to come with lower administrative costs, which puts more money back into the employee’s pocket.

Many 403(b) plans vest funds over a shorter period than 401(k)s, and some even allow immediate vesting of funds, which 401(k)s rarely do.

If an employee has 15 or more years of service with certain nonprofits or government agencies, they may be able to make additional catch-up contributions to a 403(b) plan. Under this provision, you can contribute an additional $3,000 a year, up to a lifetime limit of $15,000. And unlike the usual retirement plan catch-up provisions, you don’t have to be 50 or older to take advantage of this as long as you worked for the same eligible employer for the whole 15 years.

Disadvantages

Funds withdrawn from a 403(b) plan before age 59½ are subject to a 10% tax penalty, although you may avoid the penalty under certain circumstances, such as separating from an employer at age 55 or older, needing to pay a qualified medical expense, or becoming disabled.

A 403(b) may offer a narrower choice of investments than other plans. Although these plans now offer mutual fund options inside variable annuity contracts. you can only choose between fixed and variable contracts, and mutual funds inside these plans⁠—other securities, such as stocks and real estate investment trusts (REITs), are prohibited.

The presence of an investment option that 403(b)s favor is, at best, a mixed blessing. When the 403(b) was invented in 1958, it was known as a tax-sheltered annuity. While times have changed, and 403(b) plans can now offer mutual funds, as noted, many still emphasize annuities.

Financial advisors often recommend against investing in annuities within a 403(b) and other tax-deferred investment plans. Accounts may lack the same level of protection from creditors as plans that require ERISA compliance. If you are at risk of creditors pursuing you, speak to a local attorney who understands the nuances of your state as the laws can be complex.

Another disadvantage of non-ERISA 403(b)s is their exemption from nondiscrimination testing. Done annually, this testing is designed to prevent management-level or highly compensated employees from receiving a disproportionate amount of benefits from a given plan.

Pros

  • Earnings and returns in regular 403(b) plans are tax-deferred until they are withdrawn

  • Plans that aren’t subject to ERISA requirements come with lower administrative costs

  • Many 403(b) plans vest funds over a shorter period and some allow immediate vesting

  • Employees with 15 or more years of service may be eligible for increased catch-up contributions

Cons

  • Withdrawals before age 59½ are subject to a 10% tax penalty

  • Plans may offer a narrower choice of investments than other retirement options

  • Accounts within a 403(b) may lack the same protection from creditors as plans with ERISA compliance

  • Non-ERISA 403(b)s is exempt from nondiscrimination testing

What Are the Similarities Between 401(k) and 403(b)?

The 403(b) plan is in many ways similar to its better-known cousin, the 401(k) plan. Each offers employees a tax-advantaged way to save for retirement. Both have the same basic contribution limits: $20,500 in 2022 and $22,500 in 2023.

The combination of employee and employer contributions is limited to the lesser of $61,000 in 2022 ($66,000 in 2023) or 100% of the employee’s most recent yearly salary.

Both offer Roth options and require participants to reach age 59½ to withdraw funds without incurring an early withdrawal penalty. Like a 401(k), the 403(b) plan offers $6,500 catch-up contributions for those age 50 and older in 2022, raising to $7,500 in 2023.

What Are the Advantages of a 403(b) Plan?

Earnings and returns on amounts in a regular 403(b) plan are tax-deferred until they are withdrawn and tax-deferred if the Roth 403(b) withdrawals are qualified distributions. Employees with a 403(b) may also be eligible for matching contributions, the amount of which varies by employer.

Many 403(b) plans vest funds over a shorter period than 401(k)s, and some even allow immediate vesting of funds, which 401(k)s rarely do.

Certain nonprofits or government agencies also allow employees with 15 or more years of service to make additional catch-up contributions. Under this provision, you can contribute an additional $3,000 a year up to a lifetime limit of $15,000 and, unlike the usual retirement plan catch-up provisions, you don’t have to be 50 or older to take advantage of this.

Finally, certain 403(b) plans are not required to meet the onerous oversight rules of the Employee Retirement Income Security Act.

What Are the Drawbacks of a 403(b) Plan?

Funds that are generally withdrawn from a 403(b) plan before age 59½ are subject to a 10% penalty. One may avoid this penalty under certain circumstances, such as separating from an employer at age 55 or older, needing to pay a qualified medical expense, or becoming disabled. Plans may also offer a narrower choice of investments than the other types of retirement plans.

For 403(b)s without ERISA protection, accounts may lack the same level of protection from creditors as plans that require ERISA compliance.

Another disadvantage of non-ERISA 403(b)s includes an exemption from nondiscrimination testing. Done annually, this testing is designed to prevent management-level or highly compensated employees from receiving a disproportionate amount of benefits from a given plan.

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457 Plan

Written by admin. Posted in #, Financial Terms Dictionary

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What Is a 457 Plan?

A 457 plan is a tax-advantaged retirement savings plan offered to employees of many state and local governments and some nonprofit organizations. Like the better-known 401(k) plan in the private sector, the 457 plan allows employees to deposit a portion of their pre-tax earnings in an account, reducing their income taxes for the year while postponing the taxes due until the money is withdrawn after they retire.

A Roth version of the 457 plan, which allows after-tax contributions, may be allowed at the employer’s discretion.

There are two main types of 457 plans:

  • The 457(b): This is the most common 457 plan and is offered to state and local government employees and nonprofits. It is a retirement savings plan that offers tax advantages to participants.
  • The 457(f): This plan is offered only to highly compensated executives in tax-exempt organizations. It is a supplement to the 457(b) and it is, essentially, a deferred salary plan.

Key Takeaways

  • The 457 plan is an IRS-sanctioned, tax-advantaged employee retirement plan.
  • The plan is offered only to public service employees and employees at tax-exempt organizations.
  • Participants are allowed to contribute up to 100% of their salaries up to a dollar limit for the year.
  • The interest and earnings in the account are not taxed until the funds are withdrawn. The exception is the Roth option, if available, in which only post-tax money is deposited.

Watch Now: What Is a 457 Plan?

Types of 457 Plans

As noted, the 457 plan comes in two flavors, the 457(b) and the 457(f).

The 457(b) Plan

The 457(b) plan is most often offered to civil servants, police personnel, and other employees of government agencies, public services, and nonprofit organizations such as hospitals, churches, and charitable organizations.

It is similar to a 401(k). Participants set aside a percentage of their salary into a retirement account. The employees choose how their money is invested from a list of options, mostly mutual funds and annuities.

The account grows in value without being taxed over the years. When the employee retires, taxes will be due on the amount withdrawn.

Employees are allowed to contribute up to 100% of their salary, provided it does not exceed the dollar limit set for the year.

If the 457 plan does not meet statutory requirements, the assets may be subject to different rules.

457(b) Contribution Limits

As of 2022, employees can contribute up to $20,500 per year to 457 plans. This limit increases to $22,500 for 2023.

In some cases, workers are allowed to contribute even more. For example, if an employer permits catch-up contributions, workers over the age of 50 may pay in an additional $6,500 a year, making their maximum contribution limit $27,000 ($20,500 + $6,500) in 2022. The catch-up contribution increases to $7,500 for tax year 2023, making the maximum contribution limit $30,000 ($22,500 + $7,500).

Also, 457(b) plans feature a “double limit catch-up” provision. This is designed to allow participants who are nearing retirement to compensate for years in which they did not contribute to the plan but were eligible to do so.

In this case, employees who are within three years of retirement age may contribute up to $41,000 in 2022 and up to $45,000 in 2023. 

Advantages and Disadvantages of a 457(b) Plan

The 457(b) plan has all of the advantages of a 401(k), although there are some differences.

Advantages of a 457(b)

Tax Benefits

If a traditional rather than a Roth plan is chosen, the contributions are deducted from an employee’s paycheck on a pre-tax basis. That amount is subtracted from the employee’s gross income, effectively lowering the person’s taxes paid for that year. For example, if Alex earns $4,000 per month and contributes $700 to a 457(b) plan, Alex’s taxable income for the month is $3,300.

Employees invest their contributions in their choice or choices from a selection of annuities and mutual funds.

All interest and earnings generated from year to year remain untaxed until the funds are withdrawn.

Withdrawals Without Penalty

There is one big difference between the 457(b) and other tax-advantaged retirement plans: no penalty for early withdrawals in some circumstances.

If an employee retires early or resigns from the job for any reason, the funds can be withdrawn without incurring a 10% penalty from the IRS. Early withdrawals from most retirement plans are subject to the penalty except for certain hardship reasons. (The penalty was waived for two years during the COVID-19 pandemic.) 

A 457(b) account holder can take a penalty-free withdrawal without changing jobs, like a 401(k) account holder. The list of acceptable reasons, however, is limited to “unforeseeable emergencies.”

Exceptions to the Rules

Early withdrawals from a 457(b) are subject to the 10% penalty if the account holder rolls the funds over from a 457 to any other tax-advantaged retirement account, such as a 401(k). This would happen if, for example, a government employee quit to take a job in the private sector.

In addition, anyone who takes money out of a retirement account early must keep in mind that any income taxes due on that money will be owed in the year that the withdrawal is taken.

Disadvantages of a 457(b) Plan

One potential advantage of most tax-advantaged retirement savings plans is the employer match. An employer may choose to match some portion of an employee’s contribution to the plan. An employer who matches the first 3% of the employee’s contribution, for example, is presenting the employee with a 3% raise.

Employer Match Is Rare

Employers can match their employees’ contributions to a 457(b) but, in practice, most don’t.

If they do, the employer contribution counts toward the maximum contribution limit. This is not the case for 401(k) plans.

For instance, in 2022, if an employer contributes $10,000 to a 457(b) plan, the employee can add only $10,500 for the year until the $20,500 contribution limit is reached (except for those eligible to use the catch-up option).

457(b) Advantages

  • Looser rules for early withdrawals without a penalty.

  • Early distributions allowed for participants who leave a job.

  • As with other retirement plans, no taxes are due until money is withdrawn.

457(b) Disadvantages

  • Employer contributions count toward contribution limit the year they vest.

  • Employer contributions subject to vesting schedule. If the employee quits, non-vested funds are forfeited.

  • Limited investment choices compared to private sector plans.

457(b) vs. 403(b)

The 403(b) plan, like the 457(b), is mostly available to public service employees. They are a particularly common benefit offered to public school teachers.

The 403(b) has its origins in the 1950s when it exclusively offered an annuity to participants. Participants still have the option of creating an annuity but they also can choose to invest in mutual funds.

In fact, the 403(b) has changed over the years until it closely resembles the private sector’s 401(k) plan, although the investment choices offered to participants are relatively limited.

The annual contribution limits are identical to those of the 457(b) and 401(k) plans.

If you’re a public employee, your employer may well offer a 457(b) or a 403(b).

Advisor Insight

Dan Stewart, CFA®
Revere Asset Management, Dallas, TX

457 plans are taxed as income similar to a 401(k) or 403(b) when distributions are taken. The only difference is there are no withdrawal penalties and that they are the only plans without early withdrawal penalties. But you also have the option of rolling the assets in an IRA rollover. This way, you can better control distributions and only take them when needed.

So if you take the entire amount as a lump sum, the entire amount is added to your income and may push you into a higher tax bracket.

With the rollover route, you could take out a little this year, and so on as needed, thus controlling your taxes better. And while it remains inside the IRA, it continues to grow tax-deferred and is protected from creditors.

What Is the Difference Between a 457(b) Plan and a 457(f) Plan?

The 457(b) plan is a version of the 401(k) plan that is designed for public and nonprofit workers. It helps employees save for retirement while deferring the tax bill until they retire and start withdrawing the money. (The Roth version, which is available only at the employer’s discretion, takes the taxes upfront, so no taxes are usually due on withdrawals.)

The 457(f) plan is also known as a SERP for Supplemental Executive Retirement Plan. It is a retirement savings plan for only the highest-paid executives in the tax-exempt sector. They are mostly employed in hospitals, universities, and credit unions.

A 457(f) is a supplement to a 457(b). Employers make additional contributions to the employee’s account, beyond the usual limits. These are negotiated by contract and amount to a deferred salary adjustment.

If the executive resigns before an established vesting period, the 457(f) contribution disappears. The plan is intended as an executive retention strategy, commonly known as “golden handcuffs.”

Is a 457(b) Plan Better Than a 401(k) Plan?

For all intents and purposes, a 457(b) is just as good as a 401(k) plan. If you’re employer is a public agency or a nonprofit, it’s probably your best option for retirement savings.

Assuming you opt for a traditional plan rather than a Roth plan, you’ll be lowering your taxable income from year to year while plunking that money into a long-term investment account. The money won’t be taxed until you retire and start taking withdrawals.

(If it’s a Roth, you’ll pay the taxes up front and usually will owe no taxes on the money you deposited or the profits it earns over the years.)

On the downside, your contributions will probably not be matched by your employer. But that’s just reality in the nonprofit sector, not a rule of the plan.

How and When Can I Make Withdrawals From My 457(b) Account?

One advantage of a 457(b) is that you can take early withdrawals without paying a tax penalty for any “unforeseeable emergency.” This isn’t a good idea, since you’re plundering your retirement savings, but unforeseeable emergencies do happen. And, you’ll owe income tax for that year on the amount you withdraw.

The required minimum distribution (RMD) you must take is determined by an IRS worksheet. An RMD is a minimum amount that must be withdrawn from certain retirement plans, like a 457(b), each year once you reach a certain age. If you were born between 1951 and 1959, the age is 73. If you were born in 1960 or after, the age is 75. This is an increase from the previous age of 72.

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What Is Adjusted Gross Income (AGI)?

Written by admin. Posted in A, Financial Terms Dictionary

What Is Adjusted Gross Income (AGI)?

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What Is Adjusted Gross Income (AGI)?

Adjusted gross income (AGI) is the figure that the Internal Revenue Service (IRS) uses to determine your income tax liability for the year. It is calculated by subtracting certain adjustments from gross income, such as business expenses, student loan interest payments, and other expenses. After calculating a taxpayer’s AGI, the next step is to subtract deductions to determine their taxable income.

The IRS also uses other income metrics, such as modified AGI (MAGI), for specific programs and retirement accounts.

Key Takeaways

  • The IRS uses your adjusted gross income (AGI) to determine how much income tax you owe for the year.
  • AGI is calculated by taking all of your income for the year (your gross income) and subtracting certain adjustments to income.
  • Your AGI can affect the size of your tax deductions as well as your eligibility for some types of retirement plan contributions, such as a Roth individual retirement account (Roth IRA).
  • Modified adjusted gross income (MAGI) is your AGI with some otherwise-allowable deductions added back in. For many people, AGI and MAGI will be the same.
  • Among the items subtracted from your gross income when calculating your AGI are alimony payments and educator expenses.

Click Play to Learn All About Adjusted Gross Income

Understanding Adjusted Gross Income (AGI)

As prescribed in the United States tax code, AGI is a modification of gross income. Gross income is simply the sum of all the money you earned in a year, which may include wages, dividends, capital gains, interest income, royalties, rental income, alimony, and retirement distributions, before tax or other deductions. AGI makes certain adjustments to your gross income to reach the figure on which your tax liability will be calculated.

Many U.S. states also use the AGI from federal returns to calculate how much individuals owe in state income taxes. States may modify this number further with state-specific deductions and credits.

AGI is an important figure because it is what is used to determine your eligibility for certain deductions and credits.

Common Adjustments

The items subtracted from your gross income to calculate your AGI are referred to as adjustments to income, and you report them on Schedule 1 of your tax return when you file your annual tax return. Some of the most common adjustments are listed here, along with the separate tax forms on which a few of them are calculated:

  • Alimony payments (for divorces filed before Jan. 1, 2019)
  • Early withdrawal penalties on savings
  • Educator expenses
  • Employee business expenses for armed forces reservists, qualified performing artists, fee-basis state or local government officials, and employees with impairment-related work expenses (Form 2106)
  • Health Savings Account (HSA) deductions (Form 8889)
  • Moving expenses for members of the armed forces (Form 3903)
  • Self-employed Simplified Employee Pension (SEP), Savings Incentive Match Plan for Employees of Small Employers (SIMPLE), and qualified plans
  • Self-employed health insurance deduction
  • Self-employment tax (the deductible portion)
  • Student loan interest deduction

How to Calculate Adjusted Gross Income

If you use software to prepare your tax return, it will calculate your AGI once you input your numbers. If you calculate it yourself, you’ll begin by tallying your reported income for the year. That might include job income, as reported to the IRS by your employer on a W-2 form, plus other income, such as dividends and miscellaneous income, reported on 1099 forms.

Next, you add any taxable income from other sources, such as profit on the sale of a property, unemployment compensation, pensions, Social Security payments, or anything else that hasn’t already been reported to the IRS. Many of these income items are also listed on IRS Schedule 1.

The next step is to subtract the applicable adjustments to the income listed above from your reported income. The resulting figure is your AGI. To determine your taxable income, subtract either the standard deduction or your total itemized deductions from your AGI. In most cases, you can choose whichever gives you the most benefit.

For example, the standard deduction for tax returns for married couples filing jointly was $25,900 in 2022, rising to $27,700 in 2023, so couples whose itemized deductions exceed that amount would generally opt to itemize, while others would take the standard deduction.

The IRS provides a list of itemized deductions and the requirements for claiming them on its website. Your AGI also affects your eligibility for many of the deductions and credits available on your tax return. In general, the lower your AGI, the more significant the number of deductions and credits you will be eligible to claim, and the more you’ll be able to reduce your tax bill.

An Example of AGI Affecting Deductions

Let’s say you had some significant dental expenses during the year that weren’t reimbursed by insurance, and you’ve decided to itemize your deductions. You are allowed to deduct the portion of those expenses that exceed 7.5% of your AGI.

This means that if you report $12,000 in unreimbursed dental expenses and have an AGI of $100,000, you can deduct the amount that exceeds $7,500, which is $4,500. However, if your AGI is $50,000, the 7.5% reduction is just $3,750, and you’d be entitled to deduct a larger amount of that $12,000, in this case $8,250.

Adjusted Gross Income (AGI) vs. Modified Adjusted Gross Income (MAGI)

In addition to AGI, some tax calculations and government programs call for using what’s known as your modified adjusted gross income, or MAGI. This figure starts with your AGI, then adds back certain items, such as any deductions you take for student loan interest or tuition and fees.

Your MAGI is used to determine how much, if anything, you can contribute to a Roth individual retirement account (Roth IRA) in any given year. It is also used to calculate your income if you apply for Marketplace health insurance under the Affordable Care Act (ACA).

Many people with relatively uncomplicated financial lives find that their AGI and MAGI are the same number or very close.

If you file your taxes electronically, the IRS form will ask you for your previous year’s AGI as a way of verifying your identity.

Adjusted Gross Income vs. Gross Income vs. Taxable Income

Your gross income is all of the money you’ve earned in a year that isn’t exempt from taxation. This can be in the form of salary, wages, interest, dividends, capital gains, and so on.

Your adjusted gross income takes that amount and takes out certain qualified expenses and adjustments.

Taxpayers can then take either the standard deduction for their filing status or itemize the deductible expenses they paid during the year. You’re not permitted to both itemize deductions and claim the standard deduction. The result is your taxable income.

Where to Find Your Adjusted Gross Income (AGI)

You report your AGI on line 11 of IRS Form 1040, which is the form you use to file your income taxes for the year. Keep that number handy after completing your taxes, because you will need it again if you e-file your taxes next year. The IRS uses it as a way to verify your identity.

Also, note that as of January 2022, almost anyone may use the IRS Free File program to file their federal (and, in some cases, state) taxes electronically at no charge.

Frequently Asked Questions

What Does Adjusted Gross Income (AGI) Mean for Tax Payments?

Adjusted gross income (AGI) is essentially your income for the year after accounting for all applicable tax deductions. It is an important number that is used by the Internal Revenue Service (IRS) to determine how much you owe in taxes. AGI is calculated by taking your gross income from the year and subtracting any deductions that you are eligible to claim. Therefore, your AGI will always be less than or equal to your gross income.

What Are Some Common Adjustments Used When Determining AGI?

There are a wide variety of adjustments that might be made when calculating AGI, depending on the financial and life circumstances of the filer. Moreover, since the tax laws can be changed by lawmakers, the list of available adjustments can change over time. Some of the most common adjustments used when calculating AGI include reductions for alimony and student loan interest payments.

What Is the Difference Between AGI and Modified Adjusted Gross Income (MAGI)?

AGI and modified adjusted gross income (MAGI) are very similar, except that MAGI adds back certain deductions. For this reason, MAGI would always be larger than or equal to AGI. Common examples of deductions that are added back to calculate MAGI include foreign earned income, income earned on U.S. savings bonds, and losses arising from a publicly traded partnership.

The Bottom Line

Adjusted gross income, or AGI, is your gross income after it has been adjusted for certain qualified deductions that are permitted by the Internal Revenue Service (IRS). These qualified deductions reduce an individual’s gross income, thus reducing the taxable income that they will ultimately have to pay taxes on. You can save money come tax season by lowering your AGI, which will lower your taxable income, in turn. However, many of the adjustments allowed for AGI are specific for particular circumstances that may not apply to everyone.

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