What Is A 401(k) Plan?

A 401(k) is a workplace savings plan that allows employees to save money for retirement on a pre-tax basis. That means any money you put into your 401(k) will lower your taxable income for that year. 401(k) contributions are taken out of your paycheck on a pre-tax basis. You don’t pay taxes on any income you contribute to your 401(k) account until you retire and begin to take money out of the account.

Types Of 401(k) Plans

If you’re thinking about starting a 401(k) or are already participating in one, it’s a good idea to know about the different types of 401(k) plans, which determine how much you can save on a pre-tax basis and how the money is invested. 

There are two main types of 401(k) plans: Traditional 401(k) and Roth 401(k).

A traditional 401(k) is a defined contribution retirement plan. This means that an employer sets aside a certain amount of money for an employee’s retirement. The employee does not make any pre-tax contributions to the plan. Moreover, workers usually select a percentage of their pay that they would like contributed to the plan for the upcoming year. The employer then matches that percentage up to a certain amount. Always remember that matching contributions can vary depending on the company’s policies.

Meanwhile, a Roth IRA works a lot like a traditional IRA: you make regular contributions, and the money grows tax-free until you withdraw it. But unlike a traditional IRA, you don’t get an upfront tax deduction for your contributions. Instead, you pay taxes on those contributions and your investment earnings when you withdraw the money in retirement. But here is its significant benefit: You won’t owe any taxes on that money since it’s already been taxed. And if you’re like most Americans, you’ll probably pay a lot less in taxes in retirement than you do now, so you’ll be able to keep more of your hard-earned savings. (And if you’re really lucky, you’ll be able to withdraw your money tax-free.)

Traditional 401(k) Features

  • Employer contributions (matching or none)
  • Employee contributions
  • Contributions via profit sharing, 

Roth 401(k) Features

  • Employer contributions (matching or none)
  • Employee contributions
  • Contributions via profit sharing
  • Roth option

 

Keep in mind that a worker is allowed to avail only one of these 401(k) plans. However, it is still possible to acquire both of them at the same time.

How Does A 401(K) Plan Work?

Contributing to a 401(k) plan is one of the best things that you can do for your retirement. Not only can you adjust your contributions as your income increases (or decreases), but there is also an employer match which is essentially free money. And, if you are lucky enough to have employer stock in your 401(k) plan, then you can get certain tax advantages when you sell it to diversify your holdings. Before you start contributing to a 401(k) plan, you should decide on an amount that you will be able to put away each year.

The 401(k) is a great tax-advantaged way to save money for retirement. It has many tax benefits; one of the most essential is the employer-matching contribution. Many employers contribute to your 401(k) account on your behalf. The most common way is to match a percentage of the amount you contribute, usually up to a certain percentage of your income. For example, an employer may match 50 cents for each dollar you contribute to your 401(k) up to 6% of your income. This means that if you contribute 6% of your income to your 401(k) plan, the total amount you contribute will be 6% of your income. Employer contributions to a 401(k) are tax-deferred. 

Limits In Contribution

It is interesting to note that the amount of contribution that an employer or employee can contribute to a 401(k) is dependent on inflation. Basically, it’s adjusted every year. For instance, the limit for contribution for 2020 is $19,500 for workers under 50 years old. Meanwhile, the limit for employees 50 and above is $26,000. If the employer decides to give non-deductible contributions to the plan, the maximum limit for workers under 50 years old is $58,000. For those 50 and above, the limit is $64,500.

Also, it is essential to highlight that an employer’s contribution is only applicable to traditional 401(k) plans, not to Roth 401(k). When you withdraw them, they are subjected to tax already. 

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