A 401(k) plan is a United States retirement and savings plan that enables employees to contribute a portion of their salary or paycheck to a retirement fund that can be accessed if certain conditions are met. The contributions are made on a pre-tax basis, thereby reducing the employee’s taxable income.
Employers typically offer such plans to their employees. 401(k) plans were designed to provide taxpayers a break on taxes on deferred income, and as a supplement to pension plans that may also be offered to employees. An employer may also contribute funds to the employee’s 401(k) as well.
A 401(k) plan is a type of defined-contribution plan, in the sense that the monetary component of retirement benefits is directly proportional to the contributions of the employees into their accounts.
It is different from regular pension plans, which are defined-benefit plans, where the employer plans and calculates the amount of retirement benefits for any employee based on several factors, such as salary and duration of employment.
A 401(k) plan is a United States retirement and savings plan that enables employees to contribute a portion of their salary or paycheck to a retirement fund that can be accessed if certain conditions are met.
The contributions are made on a pre-tax basis, thereby reducing the employee’s taxable income.
Depending on the type of 401(k) plan, employees can save money on taxes by allowing them to make pre-tax contributions or to save on income taxes upon withdrawal.
Types of 401(k) Plans
There are currently two types of 401(k) plans offered by employers:
Traditional 401(k), which was first created in 1978
Roth 401(k), which was created in 2006
The primary differences between the two types of plans lie in how contributions are taxed and the terms for withdrawals.
The benefits and drawbacks of each type of plan depend on the financial status and future of the individual:
For employees in lower marginal tax brackets (who anticipate higher earnings in the future), the Roth 401(k) may be more beneficial, since they save by paying lower taxes now as opposed to paying a large amount in income taxes upon withdrawal.
For employees in higher marginal tax brackets, the traditional 401(k) may provide better value, as it allows individuals to save substantial amounts by reducing their total taxable income.
However, it is important to note that the amount of an employee’s contribution is annually capped, which means that highly compensated individuals can only save a certain amount by deferring income taxes in the future.
Features of a 401(k) Plan
1. Contribution limits
Per the latest Internal Revenue Service (IRS) guidelines for the year 2023, people under the age of 50 can contribute at most $22,500 to their accounts annually. For those aged 50 and above, the maximum limit is $30,000.
When employers match their employees’ contributions, in 2023 the combined contribution for people under 50 is $66,000. The limit for people aged 50 and above is $73,500. However, regardless of age, the combined contributions are limited to the lesser of the limits or the full amount of employee compensation.
2. Treatment of taxes
In the case of a traditional 401(k), the amount deposited into the plan reduces the taxable income of the employee, but any amount withdrawn is taxed. On the other hand, taxes are deducted from deposits made into a Roth 401(k) scheme, whereas withdrawals are tax-free.
Owners of all 401(k) accounts can start making withdrawals only after they are 59 years and 6 months old, or if they meet any other criteria as specified by the IRS rules, such as suffering from a permanent disability. Such emergency withdrawals before maturity to pay for an “immediate and heavy financial need” are allowed without any penalty. Unless there is an exception, withdrawals made before retirement will face a penalty tax of 10%.
4. Required Minimum Distribution (RMD)
Withdrawals from a 401(k) plan are sometimes referred to as distributions. Retired owners aged 72 and above must withdraw a certain proportion of the money in their accounts, as calculated based on IRS rules.
Advantages of 401(k) Plans
401(k) plans allow employees to save money on taxes by allowing them to make pre-tax contributions [Traditional 401(k)] or to save on income taxes upon withdrawal [Roth 401(k)].
For employers, 401(k) plans may reduce the cost associated with designing and implementing pension plans for employees by offering them a tax-advantaged retirement plan.
401(k) plans are also an effective way of reducing the total taxable income for individuals, allowing them to ultimately save more.
An employee can borrow against their 401(k) plan, depending on what their employer’s plan allows. Like any loan, the amount must be paid back with interest; however, the interest paid goes back into the 401(k) plan. Loans are also not subject to penalty or income taxes. In most cases, a 401(k) loan amount is the lesser of 50% of the 401(k) balance or $50,000.
401(k) Restrictions and Caveats
There are fees associated with investment management, consulting, and administration costs that must be paid upon enrollment into a 401(k) plan.
It is important to note that the contributions to a 401(k) plan, be it Traditional or Roth, are capped annually. This limit is updated each year.
A loan that is not paid back on time (usually five years) is subject to fees, penalties and taxes. If the employee changes jobs before the loan is repaid, the outstanding balance is considered a distribution if not paid back in full within 60 days of leaving the company.
A crucial restriction that is typically placed by companies as insurance against employee turnover is time worked. Vesting refers to giving employees the right to secure an asset. In the context of 401(k) plans, vesting refers to providing employees with access to funds in their respective retirement accounts. Most employers require employees to work a certain period before they’re vested.
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