401(k) 101: The Basics Behind Retirement Accounts and Planning

Retirement planning can be overwhelming, especially with so many different account options available. As financial advisors, we often find that high-earning employees — especially those in tech — do not fully take advantage of their companies’ retirement benefits. 

Below, we explore the types of retirement accounts, how they work, and some unique tax advantages you should know about.

401(k) Plans: The Power of Pre-Tax Contributions

401(k) plans are powerful retirement savings vehicles that allow employees to contribute pre-tax income. We’re talking about reducing taxable income today while growing the investment tax-deferred until retirement. Woohoo!

The IRS explains the basics:

• Elective salary deferrals are excluded from the employee’s taxable income (except for designated Roth deferrals).
• Employers can contribute to employees’ accounts.
• Distributions, including earnings, are includible in taxable income at retirement (except for qualified distributions of designated Roth accounts).

What to know About Employer Contributions

Most employers offer matching contributions, matching a percentage of your salary up to a certain amount. For instance, Amazon, Google, Microsoft, and Meta all offer competitive 401(k) plans, but many employees don’t fully leverage the benefits. According to some experts, the best way to take advantage of a 401(k) match is to set up payroll withholding. We recommend adjusting your withdrawal amount to achieve the maximum contribution amount.

If you’re not contributing enough to get the full match, you’re leaving money on the table — what a scary financial mistake! 

Pre-Tax vs. Post-Tax (Roth) 401(k) 

While traditional 401(k) contributions are made with pre-tax dollars, Roth 401(k) contributions are made with after-tax dollars. The main difference lies in taxation: Roth 401(k) contributions won’t reduce your taxable income today, but come retirement time your withdrawals will be tax-free. 

When we advise clients, we analyze their current tax brackets compared to expected tax brackets. We consider the medium to long term and advise on the most efficient mix of pre-tax and Roth contributions for each stage of life and income level. 

One thing to note is that employer matches go in as pre-tax contributions.

Mega Roth 401(k) — A Hidden Gem for High Earners

For tech employees working at top companies, the Mega Backdoor Roth 401(k) option can be a game-changer. These let employees contribute beyond the standard contribution limit — up to $69,000 annually for 2024. 

This breaks down as follows:

• Employee contribution: $23,000 (including catch-up contributions for those over 50).
• Employer contribution: Actual dollar amount contributed by the employer (varies).
• After-tax contribution: Up to $36,000, depending on employer contributions.

The Mega Roth is available in certain 401(k) plans, but many employees don’t realize they can access it. The after-tax contributions are typically “swept” daily into a Roth IRA, allowing for tax-free growth and withdrawals.

Why is this important? If you can contribute the maximum amount to a Mega Roth 401(k), you’re supercharging your tax-free retirement savings. However, navigating this benefit and the associated tax implications can be tricky, especially with nuances like daily sweeps.

Reach out to your financial advisor for assistance!

Does your company offer a Mega Roth Backdoor 401(k)? If you work at Google, Amazon, Meta, Microsoft, or one of these 50 companies, chances are high! Talk to your financial advisor about how to take advantage of this investment option.

Individual Retirement Accounts (IRAs)

IRAs offer another avenue for retirement savings. There are two primary types:

Traditional IRA: Contributions may be tax-deductible, and your investments grow tax-deferred, but withdrawals in retirement get taxed as income.

IRA deduction phaseout for active participants:

• Single $77,000–$87,000
• Married filing jointly $123,000–$143,000
• Married filing separately $0–$10,000
• Non-active participant married to active participant $230,000–$240,000

Roth IRA: Contributions are made with after-tax dollars, but qualified withdrawals in retirement are tax-free. However, there are income limits that determine eligibility.

Roth IRA phaseout:

• Single $146,000–$161,000
• Married filing jointly $230,000-–$240,000

SEP IRA: Ideal for Self-Employed Individuals

A SEP IRA is a simplified employee pension plan designed for self-employed individuals and small business owners. 

Vanguard explains contribution limits as such:

• You can contribute up to 25% of your total compensation or a maximum of $66,000 for 2023 tax year or $69,000 for the 2024 tax year, whichever is less.

• If you’re self-employed, your contributions are generally limited to 20% of your net income. (Net compensation for self-employed individuals is generally the net profit from IRS Schedule C reduced by the deductible self-employment tax. The eligible compensation limit, indexed for inflation by the IRS, is $330,000 for 2023 or $345,000 for 2024.)

• Contributions are deductible and aren’t required every year.

• SECURE 2.0 allows employers of SEP-IRAs to offer the ability to make Roth contributions. 

SEP IRAs are flexible and have higher contribution limits than traditional or Roth IRAs, making them attractive options for entrepreneurs. The IRS outlines the guidelines for a SEP IRA here.

Individual 401(k): Retirement Planning for Small Business Owners

An Individual 401(k) (also called a Solo 401(k) or one-participant 401(k)) is an option for small business owners with no employees. It offers both the employee and employer contribution opportunities, meaning you can contribute as both the employee and the employer. This enables higher contribution limits, up to $69,000 if you’re under 50, similar to the Mega Roth option but specifically designed for self-employed individuals.

Simple IRA: A Cost-Effective Option for Small Employers

For small businesses looking for a cost-effective retirement plan, there are Simple IRAs. These allow employees to contribute, and employers must match or make nonelective contributions for all employees. Simple IRAs are typically easier to administer than a 401(k), but they have lower contribution limits. The IRS clarifies: The amount an employee contributes from their salary to a SIMPLE IRA cannot exceed $16,000 in 2024 ($15,500 in 2023; $14,000 in 2022; $13,500 in 2020 and 2021; $13,000 in 2019 and $12,500 in 2015 – 2018).

Defined Benefit Plans: The Old-School Pension

Though the phasing out of these plans started in the 1980s, defined benefit plans (traditional pensions) still exist for some. Pensions guarantee a specific payout at retirement, often based on salary history and years of service. Unlike 401(k)s or IRAs, where the payout depends on investment performance, defined benefit plans promise a fixed income stream, typically for life.

Talk to Your Financial Advisor About Taking Advantage of Retirement Benefits

Many high-earning tech employees come to us without realizing the full potential of their retirement benefits. For instance, many aren’t aware that they could be maxing out their contributions to the Mega Roth option or that the daily sweep into a Roth IRA could help them avoid unnecessary tax hits.

When multiple retirement accounts are available, it’s essential to choose the right mix based on your current income, tax situation, and long-term goals. At Northern Lights Advisors, we help clients optimize these choices to retire confidently, knowing they’re making the most of every opportunity. Contact us today to schedule a consultation.

Northern Lights Advisors is a fiduciary, fee-only Registered Investment Advisor (RIA) firm based in Seattle, Washington. The information in this article is not intended as tax, accounting, or legal advice. Read the full disclosure here.