A 401(k) is basically a retirement savings plan offered by many employers in the United States, sometimes as part of a benefits package. Any employee who signs up for a 401(k) plan accepts that a percentage of each paycheck will be paid directly into an investment savings account. In some cases the employer will match part, sometimes all, of your contribution.
It can be difficult for younger employees to be concerned about their retirement years; however, any financial professional will advise that everyone should start planning for their retirement as early as possible. Any company who offers employees a 401(k) plan is, in effect, helping you plan for your golden years without too much thought or effort on your part.
What Is A 401(K) Plan?
Congress first designed the 401(k) plan in 1978 to encourage Americans to put money aside for their retirement. Then, in 2006, the Roth 401(k)s became available. These are both employer-based savings accounts, commonly referred to as defined-contribution plans. The key difference between these two types of 401(k) plans is how they’re taxed. Under IRS Guidelines, your 401(k) retirement savings plan is eligible for special tax benefits.
The idea behind a 401(k) plan is that you, the employee, contribute pre-tax money from your salary, thus lowering your taxable income and immediately reducing your tax bill. While in the 401(k) account, your money grows through long-term investment and boosts your retirement savings, free from taxes. Your retirement savings account receives an extra boost if your company also contributes to your account.
With a traditional 401k) plan the investment earnings are not taxed until such time as the money is withdrawn, usually after retirement. At that time the money is entirely in the employee’s hands.
With most 401(k) plans a pre-set amount is deferred from your paycheck, but you may decide to set a higher or lower rate of savings, depending on your company’s offerings and your own financial situation.
The IRS sets an annual limit on the amount of money that can be set aside in a 401(k). This limit changes as it’s adjusted for inflation; however in 2021 employees under 50-years of age can set aside $19,500. This amount increases for older employees. If you’re financially stable and your employer is matching your contributions dollar-for-dollar, it would be a smart decision to contribute as much as possible into your 401(k).
It’s very important that you have a clear understanding of your company’s 401(k) plan – then you can make the most of it!
What Are Your 401(K) Options?
If the account is a traditional 401(k) there are immediate tax advantages for the employee; however, if it’s a Roth 401(k) the tax advantages come after retirement. With a traditional 401(k) the money earned will not be taxed until withdrawn for retirement; however, if it’s a Roth 401(k) there will be no taxes due when the money is withdrawn.
Here are the main differences between these two plans –
Traditional Pre-Tax 401(k)
There are two ways you save on taxes with a traditional 401(k) plan. You pay less income tax because your reported salary is decreased by the amount put into your account. In addition, the money in your account continues growing, tax-deferred, which means you don’t pay tax on the gains each year. Tax will only be paid on the amount withdrawn at retirement.
With a Roth 401(k) employees can make tax-free withdrawals because their contributions are made with ‘after-tax’ money, meaning that income taxes are paid up front. This is different to a traditional 401(k) because you save on future taxes. Another difference is that your income is not reduced by the amount you contribute to your 401(k) account. Your account will continue growing, and when you withdraw your money at retirement it will be tax-free.
Limits to Contributions
The contribution limit for the tax year 2021 is $19,500 per person. The combined contributions for those with multiple plans are capped at $19,500.
How To choose The Right 401(k) Plan For You
If you work for an employer that offers both types of plans - 401(k) and Roth 401(k) – it’s up to you to determine which one is right for your own particular circumstances. You’ll be paying taxes on a Roth 401(k) plan right now, and you’ll pay taxes when withdrawing your money on a pre-tax 401(k) plan. For most people, it’s this differentiation between the two plans that helps decide which one is right for them.
Some employees prefer to make Roth contributions during the early days of their career when their salary is lower and the tax rate is not very high. This means the impact on their dollars is not as drastic as it would be with a higher salary and a higher tax rate. Alternatively, other employees choose to make pre-tax contributions to their 401(k) during the later days of their career when both their salary and tax rate are higher.
About Individual Retirement Accounts (IRAs)
In addition to your employer’s 401(k) plan you can also choose to open an Individual Retirement Account (IRA). This type of account is well-suited to employees who are just beginning their career and their employer is only offering a pre-tax 401(k) plan. Having a Roth IRA plan allows these employees to make after-tax contributions while having a lower tax rate.
Know Your Investment Options
Many 401(k) plans allow employees to choose their own investment options, such a different mutual funds. It’s very important that you explore these options thoroughly to determine which investment option/s best suit your circumstances.
Will Your Employer Also Contribute To Your 401(k)?
Many employers make contributions to their employees’ 401(k) plans. Because these contributions are pre-tax, you’ll only be required to pay taxes on this money when withdrawn at retirement.
Note that there are three main types of employer contributions –
- Matching: Matching employer contributions means the employer will contribute the same amount of money to your 401(k) that you do. In some instances there’s a minimum amount the employer can contribute, so many employees choose to also contribute that minimum.
- Non-Elective: This means that the employer will contribute the same percentage for each employee, regardless of whether or not the employee is also contributing.
- Profit-Sharing: With a profit-sharing 401(k) plan the employer will nominate a dollar amount (or percentage) of the company’s profit to their employees’ 401(k) plans.
Learn About ‘Vesting’
In many cases, employees are only able to keep their employer’s contributions after they’ve worked in the company for a specific number of years. This is known as ‘vesting’. Once that number of years has passed you’re now ‘vested’ and you own the contributions made into your 401(k) by your employer.
It’s important to know when you are vested. This will ensure you make the most of your employer’s 401(k) plan. If you’re considering leaving your employment you may decide to wait until you’re vested, thus allowing you to take full advantage of your employer’s contributions.
Be sure that you fully understand all the ins-and-outs of your company’s 401(k) plans so you fully appreciate how to make the best plan for your own needs and goals.