A 401k is an employer-sponsored retirement account. It allows an employee to dedicate a percentage of their pre-tax salary to a retirement account. How does it Work?
Contributions are automatically withdrawn from employee paychecks and invested in funds of the employees.
You may be asking where the name 401(k) originated from. The name comes from the section of the tax code, specifically subsection 401(k). Employees contribute money to an individual account by signing up for automatic deductions from their paycheck. Depending on the type of plan you have, the tax break comes either when you contribute money or when you withdraw it in retirement.
The plan enables the employers to sponsor a retirement savings plan for employees.
How 401k Works
A 401k plan is a benefit commonly offered by employers to ensure employees have dedicated retirement funds. The employee chooses a set percentage that is automatically taken out of the paycheck and invested in a 401k account. They are made up of investments (usually stocks, bonds, mutual funds) that the employee can pick themselves.
Depending on the details of the plan, the money invested may be tax-free and matching contributions may be made by the employer. If either of those benefits are included in your 401k plan, financial experts.
Types of 401(k) Plan
There are many plans but, in this article, we are going to discuss the two main ones: Traditional 401(k) and Roth 401(k).
What Is a Traditional 401(k) vs a Roth 401(k)?
Many 401(k) plans offer the option of making traditional contributions or Roth contributions. Both types of 401(k) contributions grow tax-free. The primary differences between a traditional 401(k) and a Roth 401(k) is in the way that contributions are made and how withdrawals are taxed.
How a Traditional 401(k) Works
- Traditional 401(k) contributions: made on a pre-tax basis, which reduces taxable income for the 401(k) participant.
- Traditional 401(k) withdrawals: taxed as ordinary income at the individual’s top federal tax rate.
How a Roth 401(k) Works
- Roth 401(k) contributions: made on an after-tax basis.
- Roth 401(k) withdrawals: tax-free to the individual, if made after age 59 1/2.
What are the Benefits of a 401k?
401 tax benefits are hard to dispute, as they can offer workers a lot of financial security, including:
- Employer match
- Tax breaks
- Shelter from creditors
Let’s explore further the above benefits
401k employer match
Do you like free money? Good, now that we’ve got that out of the way, a company-matched 401k is basically that. Many employers offer to match employee contributions, either dollar for dollar or 50 cents to the dollar, up to a set limit. So, for example, say you make $100,000 a year (#baller) and your employer offer a 401k matching of 50% up to the first 6% you elect to contribute. If you contribute 6% of your annual earnings ($6,000), your employer would contribute an additional 50% of that amount. So, 3,000 free dollars.
401k tax breaks
The tax benefits of 401ks are like the triple-crown of finances. First, contributions are pre-tax. You don’t pay taxes on the money until you withdraw it when you retire.
Second, your 401k contributions are not counted as income, which could put you in a lower tax bracket. The result: your tax bill will be smaller for your having squirreled away money for your later years.
Third, your savings grow tax-deferred. In a regular investment account, your net gains and dividends would be taxed. But in a 401k plan, your money grows tax-free as long as it stays in the plan. This allows your earnings to compound — which is just a fancy way of sayings, your earnings will earn earnings.
It is clear that, depending on the type of 401(k) plan, you get a tax break either when you contribute or when you withdraw money in retirement. Well, the IRS can charge you income taxes only once.
401k shelter from creditors
If your finances take a turn for the worst, you won’t have to worry about creditors coming for your 401k. Your qualified retirement plan is protected by the Employee Retirement Income Security Act of 1974 (ERISA) from claims by judgment creditors.
What Happens When you change the Job?
If you leave your job someday for another, you can (and should) take your 401(k) with you. This won’t go into a box with your other belongings. Here are the choices incase you leave the job:
- Cash out your 401(k): You may cash out the vested portion of your 401(k) balance and have the money sent to you. This is called a lump sum distribution. Keep in mind that taxes and a penalty may apply.
- Rollover to another retirement account: 401(k) plans are transferable to other qualified retirement plans, such as an IRA or another 401(k). A direct transfer is called a rollover and is not taxable to the individual.
- Leave the money in your 401(k): You have the right to keep your money in the 401(k). Generally, your employer may force you to take a distribution if your balance is below $5,000. Some employers have lower minimum balance requirements.
Keep in mind that new contributions to a 401(k) can only be made through payroll. So, after you terminate employment, and you’re no longer on the payroll, you won’t be able to make new contributions. However, after you leave your job, your 401(k) can continue to grow over time and you’ll still have the ability to monitor your account and make investment changes.”
When Can You Withdraw from a 401(k)?
The rules for withdrawing money from a 401(k) plan are relatively strict. While these rules may vary from plan to plan, 401(k) participants may generally make withdrawals for four primary reasons: 1) death, 2) termination of employment, 3) retirement, or 4) hardship.
What Is the Penalty for Withdrawing from a 401(k) Early?
The IRS penalty for withdrawing early from a 401(k) is 10% of the amount of withdrawal. You may also owe any applicable taxes, in addition to the 10% penalty. You can withdraw from a 401(k) without paying a penalty once you reach age 59 1/2.
In addition to the 10% early withdrawal penalty, there is also a mandatory 20% withholding for federal taxes when you take a lump distribution from a 401(k) funded with traditional (pre-tax) contributions.
