What is a 401(k) Plan? Working and Types

What is 401(k) plan
What is 401(k) plan

What is a 401(k) plan and how does it work?

An employer-sponsored retirement savings and investment plan, a 401(k) plan provides employees with a tax break on their contributions. The plan automatically deducts contributions from the employee’s paycheck and invests them in funds of their choice from a list of available offerings, with an annual contribution limit of $22,500 in 2023 ($30,000 for those aged 50 or older).

The name derives from the section of the tax code that created the plan. By signing up for automatic deductions from their paycheck, employees can contribute money to an individual account, with the tax break applying either at the time of contribution or withdrawal in retirement, depending on the type of plan.

Additionally, sometimes the plan includes free money, which could be easy to miss during employee orientation.

What is the process for obtaining a 401(k)?

An employer provides a 401(k) retirement savings and investing plan to its employees. This plan allows employees to receive a tax break on their contributions. Employees can choose to have their contributions automatically withdrawn from their paychecks and invested in various funds offered by the plan. The annual contribution limit for 2023 is $22,500 ($30,000 for those aged 50 or older).

The name “401(k)” is derived from the section of the tax code that established this type of plan. Employers may offer to match a portion of their employees’ contributions, which is often the most talked-about perk of a 401(k) plan.

If your employer offers to contribute extra money to your account based on how much you contribute, such as a dollar-for-dollar or 50-cents-on-the-dollar match up to 6% of your contribution amount, it’s worth filling out the paperwork to participate. You should contribute enough to your account to take advantage of this free money.

One of the benefits of a 401(k) plan is that it automates retirement savings and simplifies investing. You can choose your own investments from the plan’s selection or have the plan select them for you. If you prefer a certain percentage of stocks versus bonds, you can request it, and the plan will automatically rebalance your portfolio to keep those percentages in line with your request.

While the investment options in a 401(k) plan can be limited, not all employers offer access to a 401(k) plan. However, you can still receive the same tax benefits by using an individual retirement account (IRA) as another major retirement savings vehicle.

What is an IRA? An IRA, or individual retirement account, provides various benefits, such as a wider range of investment options and lower fees. However, it also has some drawbacks, including lower contribution limits and eligibility restrictions for high earners. Understanding the differences between an IRA and a 401(k) can help you determine how to leverage both for your retirement savings.

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Types of 401(k) Plan

It’s worth noting that there are different types of 401(k) plans available, but the two most common ones are the traditional 401(k) and the Roth 401(k). With the traditional 401(k), you receive an initial tax benefit on your contributions. On the other hand, contributions to a Roth 401(k) are made using after-tax income, meaning you cannot deduct them from your annual taxes. However, the Roth 401(k) offers a benefit later on. Read on for a more detailed comparison of the two.

Roth 401(k)

If your employer provides a Roth 401(k) option, which not all do, you can contribute money after taxes and your distributions will be tax-free during retirement. The Roth 401(k) offers the same tax protection as a traditional 401(k) on your investments while they remain in the account.

You owe nothing to the IRS on the money as it grows, and unlike qualified withdrawals from a regular 401(k), you owe the IRS nothing when you start taking distributions. Why? Well, because you’ve already paid taxes on your contributions since they were made with after-tax dollars.

Any income earned from the account, such as dividends, interest, or capital gains, grows tax-free, and when you withdraw money during retirement, you and Uncle Sam have already settled up.

Both the Roth and traditional 401(k) plans have regulations regarding withdrawals. While there are some exceptions, generally, you cannot take distributions from your account until you’re 59 1/2 years old without incurring extra taxes or penalties. It’s worth noting that starting in 2024, plan participants will be able to make a hardship withdrawal of up to $1,000 for emergency expenses.

Traditional 401(k)

When contributing to a traditional 401(k) plan, the money is taken out of your paycheck before taxes are deducted, allowing your savings to grow tax-free. For instance, if the IRS usually takes 20 cents of every dollar earned for taxes, saving $800 a month outside of a 401(k) necessitates earning $1,000 a month, which is $800 plus $200 to cover the taxes.

In addition to increasing your savings power, pretax contributions also reduce your total taxable income for the year. For instance, if you make $65,000 per year and contribute $19,500 to your 401(k), you will only owe taxes on $45,500 of your salary instead of the entire $65,000 you earned. Once the money is in the account, it is protected from taxation as long as it remains in the account, including the investment growth, interest, dividends, and other gains.

However, the traditional 401(k)’s tax-deferred contributions and investment growth are eventually subject to income taxes when withdrawn in retirement. This is where the Roth 401(k)’s advantage becomes apparent.

401(k) changes

Due to inflation, the annual contribution limit for 401(k) plans has increased. In 2022, the limit for individuals was $20,500, which was raised to $22,500 in 2023. Those aged 50 and above have an even bigger limit, with $30,000 allowed in 2023, compared to $27,000 in 2022.

Additionally, if you are not currently participating in your company’s 401(k) plan, take note that a spending bill signed by President Biden mandates automatic enrollment in 401(k) and 403(b) plans starting in 2025 for eligible employees.

The automatic contribution begins at a minimum of 3%, with incremental increases of 1% per year until the annual contribution reaches a minimum of 10%, but not exceeding 15%. Existing 401(k) and 403(b) plans are grandfathered in under this legislation.

A significant benefit of 401(k) plans is that the funds belong to you and can be moved to a new account if you leave your job. To avoid high taxes and fees, it’s advisable to transfer your 401(k) to an IRA for many people.

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