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What is a 401(k) Plan? Definition and Basics

What is a 401k Plan
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Saving for retirement should be the goal of every employee, which allows you to live a comfortable life at a point when you're no longer able to work. One of the most popular retirement investment vehicles is the 401(k) plan.

But what is a 401(k) plan, and how does it work?

A 401(k) plan is a retirement savings plan offered by employers that provides a tax break on your contributions. Your employer deducts the contribution from your paycheck and invests it in your chosen fund. During your retirement, withdrawals from the account provide you with an income. 

In this article, you will find out all you need to know about 401(k) plans and how they work. In addition, you will find useful information on the different 401(k) plans available and how to make the most out of your plan.

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What is a 401(k) Plan?

A 401(k) is a defined contribution saving and investment plan offered by employers to their employees for use during retirement. After contributing a portion of your salary and depending on your preference, the employer invests the funds in bonds, stocks, cash, or mutual funds. 

Upon retirement, you can withdraw the total contributions plus investment growth to provide income or supplement Social Security benefits.

The plan's name originates from subsection 401(k), a section of the U.S. Internal Revenue Tax Code that instituted the plan. Both the employer and employee contribute to the account up to the limit amount as defined by the Internal Revenue Service (IRS).

You might wonder how a 401(k) plan differs from a traditional pension plan.  Traditional pension schemes are defined-benefit plans where the employer provides you with a certain amount of money when you retire. 

But with a 401(k) plan, you are responsible for your own retirement savings.

How a 401(k) Plan Works

During employment, you make monetary contributions to a dedicated retirement savings account, which are automatic, since your employer deducts the amounts from your paycheck every month. 

You then receive tax breaks on your contributions.

The tax break takes effect either at the point of contribution or later when you make a withdrawal, which depends on the kind of 401(k) plan you signed up for. In other words, your investment earnings will only attract tax when you withdraw your money after retirement. 

But that's not all, because, with a 401(k) plan, you get free money too.

Your Employer Can Match Your Contribution

Most employers contribute an amount equal to a portion of your contribution towards your 401(k) plan. 

Some will even match your contribution to the dollar. This means that if you contribute 6% of your earnings to your 401(k) and your employer matches your contribution, they will send a similar amount to your 401(k).  

Employers usually cap their contribution to around 6% of your contribution amount, with the majority offering 50 cents to the dollar. 

Most company matches also take effect once you put in a minimum of 3% of your salary. However, with most of the company matches, you'd need to put up a significant amount to access the maximum amount.

Still, a company match is one of the most significant advantages of signing up for a 401(k) plan.  Over time, the extra money received allows your savings to grow exponentially, making a remarkable difference in your retirement account. 

The beauty of a 401(k) plan is that changing employers does not affect it at all, as you simply roll over the account to a new one and continue making contributions through your new employer. 

If the new company doesn't offer 401(k) plans, you can open an individual retirement account (IRA).  There's also the option of cashing out on your plan, but you might not want to go that route.

Cashing out on a 401(k) plan attracts punitive penalties, which include paying your income tax plus an extra 10% withholding fee. 

Your 401(k) Plan Features a Vesting Schedule

Your employer might require you to work for a certain number of years before allowing you to take full ownership of their matching contributions. This vesting schedule allows for 2 types of company match ownership:

  • Cliff vesting: Here, you earn 100% of the matching contributions after a specific period
  • Graduated vesting: Your portion of the matching contributions gradually increases until you attain full ownership. 

Types of 401(k) Plans

There are two main types of 401 (k) plans, including the traditional 401(k) and Roth 401(k) plans. Both feature the same contribution limits. 

The main difference between them is in the timing of the tax application. As an employee, you can sign up for either the traditional 401(k) plan or the Roth 401(k), or you could sign up for both.

Let's take a deeper look at each of them.

Traditional 401(k) Plan

Contributions and investment growth in a traditional or regular 401(k) plan are tax-deferred. This means that income tax payment is put off until retirement when you typically begin taking distributions.

Your employer deducts the contributions towards a traditional 401(k) plan from your paycheck before the IRS takes its share. Doing so allows you to benefit from upfront tax breaks, enabling your contributions to reduce their tax amount during each contribution year. 

Here are two advantages of investing in a traditional 401(k) plan:

  • It's easier to save more in a traditional 401(k) plan. Using pretax contributions makes saving less painful. Besides, you become motivated to save a lot more for your retirement since each dollar counts, boosting your savings.
  • The contributions can impact your taxes positively. Pretax contributions help reduce your total taxable income for the contribution year, enabling you to save more. For example, if your annual salary is $50,000, and you put $15,000 towards your 401(k), you'd only need to pay tax on $35,000.  

Roth 401(k) Plan

Since you make contributions towards your Roth 401(k) with post-tax income, you are not eligible to receive a tax break for that year. This means you cannot deduct the contribution amount from taxes accrued within the year. 

With Roth 401(k), the payoff comes during retirement, when you get to make tax-free withdrawals. So unlike withdrawals from a traditional 401(k), you do not owe the IRS any income taxes when you start making withdrawals. 

  • You get tax issues sorted at the onset. The IRS charges income taxes once, when you make your contributions or when withdrawing. With a Roth 401(k), you pay your taxes from the get-go since you make contributions using post-tax dollars. Then, at the point of withdrawal, you owe the IRS nothing. 
  • You can roll over your funds to a Roth IRA. This helps you avoid taking out a Required Minimum Distributions (RMDS).
  • No withdrawal requirements. There are no special requirements when to withdraw your money with a Roth 401(k). This makes it an ideal vehicle for bequeathing wealth to your children, especially if you have other investments and don't require the funds in your retirement.

It's important to note that investment growth in a 401(k) account does not attract any taxes as long as the money stays in the account. This is the same for either the traditional or Roth 401(k) and covers interest, dividends, and other investment gains.

How to Invest in a 401(k) Plan

It's easy to get a 401(k) if you have a job, as you simply sign up through your employer. 

However, not all employers provide access to this retirement savings and investment plan. If your employer falls in this category, all is not lost. You can still get the tax benefits offered by a 401(k) plan by making your contributions through an individual retirement savings account.

When signing up for your 401(k), you will need to choose your specific investments from the selection offered by your employer. 

The selection could include some of the following investments: 

  • Company stock
  • Stock and bond mutual funds
  • Target-date funds comprising a mix of stocks and bonds
  • Guaranteed investment contracts (GICs) from insurance companies 

Should You Choose a Traditional or Roth 401(k)?

Both plans are excellent, but you might want to choose based on your financial circumstances. 

Choose a traditional 401(k) if you expect to fall into a lower tax bracket in your retirement, which will help you leverage on the immediate tax break. However, if you see yourself in a much higher tax bracket, choose the Roth 401(k) and avoid paying taxes later.

A Roth plan also makes sense if you are newly employed with many working years ahead of you. Your salary might be low now, but it will increase over time, giving you the opportunity to compound your tax-free earnings with money earned over the years.

How to Decide If You Should Max Out Your 401(k)

Financial planners recommend that one way to maximize your 401(k) is to ensure that you contribute enough to qualify for your employer's matching contribution. 

But should you also save up to the maximum allowable limit? 

If you can afford to, then you should go ahead and save the maximum amount. The great thing about this investment strategy is that it doubles your retirement funds without reducing your income or raising your tax burden. 

However, if you can't, then consider depositing any bonuses due to you directly into your 401(k). 

Another reason that might make you want to max out your 401(k) is that most employers base their employee salaries on full matching. This means that failure to take advantage of an employee match would be like saying no to free money.

Required Minimum Distributions (RMDs)

After 59½ years, you can start making withdrawals from a traditional or Roth 401(k). Individuals with a permanent disability are also eligible to make withdrawals. 

You don't have to make withdrawals if you have no need for the money, though. 

But once you attain 72 years of age, you must start taking Required Minimum Distributions. 

Failure to abide by this stipulation from the IRS attracts a 50% penalty. Note that RMDs are not applicable if you are still an employee of the company sponsoring the 401(k) plan.    

If you are 72 but have no need to make withdrawals from your Roth 401(k), a good option is to roll over the funds to a Roth IRA. This plan does not require you to take out any RMDs during your lifetime.

How to Make the Most Out of Your 401(k) Plan

To make the most out of your 401(k) plan, start by calculating how much you need to contribute. 

This means taking the maximum allowable contribution in the year ($19,500 and $58,000 for the combined limit in 2021) and dividing it by the pay periods. You will then arrive at the amount you need to make per paycheck.

A sizable contribution along with good investment returns on the savings is enough to provide you with a comfortable retirement and sufficient income to supplement Social Security funds. 

But if you are still unsure about how much you need to contribute to your 401(k), try to estimate the amount of income you will need in your retirement years. To help you out on this, use a retirement calculator.

Consider doing the following as well:

  • Be consistent by contributing a specific amount per paycheck.
  • Whenever possible, try and save at least 15% of your gross income. 
  • Take note of the underlying fees of all the investments that make up your 401(k).
  • Avoid timing the market or halting your contributions due to an unfavorable economic outlook.
  • Ensure that the contribution to your 401(k) is enough to allow you to qualify for a matching contribution from your employer.
  • Find out the terms of your plan's vesting schedule, as your matching contributions could revert to your employer if you leave before you become fully vested.

Final Thoughts

When it comes to providing for a secure retirement, you are completely on your own, unless you take advantage of retirement savings plans like the 401(k), a tax-advantaged retirement investment plan that helps you save for your future. 

With this plan, your savings grow within a tax-deferred account, plus you also get the chance to double your retirement savings with your employer's matched dollars.

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