What Is a 401(k) Plan?
A 401(k) plan stands as a retirement savings scheme, commonly provided by numerous American employers, offering valuable tax benefits for individuals. Its nomenclature is derived from a specific section within the U.S. Internal Revenue Code (IRC).
Under this arrangement, the participating employee consents to allocating a portion of their earnings directly into an investment account, with the potential for the employer to match some or all of this contribution. Within this framework, the employee enjoys the flexibility of selecting from an array of investment choices, typically revolving around mutual funds.
Key Points to Remember:
- A 401(k) plan is an employer-sponsored retirement account that allows employees to contribute a portion of their income, with the possibility of employer contributions.
- There exist two fundamental types of 401(k) plans—traditional and Roth—distinguished primarily by their taxation methods.
- In a traditional 401(k), employee contributions are pre-tax, meaning they reduce taxable income, but eventual withdrawals are subject to taxation.
- Roth 401(k) contributions are made with post-tax income, with no tax deduction in the contribution year, but withdrawals are tax-free.
- Employers can contribute to both traditional and Roth 401(k) plans, further enhancing retirement savings opportunities.
If you have been planning for retirement, you would know there are many types of tax-deferred retirement plans. One such popular plan is a 401(k) offered by employers and it is much more than an employee perk. The best thing about this plan is that while it provides greater stability within the business to the employers, it allows the employees to better achieve their long-term financial goals for retirement.
Have a look at some of the benefits a 401(k) can offer you as an employee:
Simple Payroll Deduction
AARP found out that Americans are 15 times more likely to save for retirement if they are given an option to a payroll deduction savings plan. 401(k) is one such plan where the employee contributions are deducted from every individual’s paycheck automatically based on their salary. It is usually a certain percentage of their income, and it gets easily deducted by the company.
Tax-Advantaged Savings
A 401(k) plan offers both pre-tax and after-tax contributions.
- Pre-tax contributions – There are contributions like traditional (pre-tax) salary deferrals, matching, safe harbor, and profit-sharing contributions that don’t get taxed when they are made. Their amounts, and any earning thereupon, are tax-deferred until distribution.
- After-tax contributions– Unlike pre-tax contributions, these are taxed when made and tax-free when distributed. These include Roth deferrals and voluntary contributions.
Greater Contribution Limits
You can make higher annual contribution limits with 401(k) plans when compared to IRAs. It allows you to save at a faster rate and plan your retirement before IRA account holders.
Benefit of Compound Interest
Compound interest is a great tool for building wealth. Once your savings are invested, you start to earn interest on it and soon you get more interest on this compounded amount. So, owing to compound interest, your earnings on 401(k) contributions can quickly grow over time and you end up with a substantial amount at the time of retirement.
Dollar-Cost Averaging (DCA)
The regular contributions that are automatically deducted from your salary work on the DCA strategy. From every contribution, you buy a different number of investment shares (fewer when they are expensive and more when they are cheaper). So, it makes it easy for you to participate in the long-term gains of an investment.
Tax Credits
Another advantage of this plan is that it allows low and moderate-income workers to be eligible for a Saver’s Credit. The maximum contribution amount that may qualify for the credit is $2,000.
Ease of Portability
Lastly, if you decide to leave your current employer, you are entitled to an immediate distribution of your 401(k) account. You can also roll this amount to your new employer’s 401(k) plan or a personal IRA.
Saving for your retirement is one of the most important things that you should do during your working years. You can’t expect to work forever and you need a plan to meet your living expenses once you stop earning a paycheck. The above-mentioned 401(k) benefits can make it easy and affordable for you to achieve your retirement goals.