Many American employers offer 401(k) plans to their employees for retirement savings. These are based on a section of the Internal Revenue Code of the United States. With a 401(k), the employee agrees to have a percentage of each paycheck paid directly into an investment account. The employer may match part or all of the employee’s contribution. So, the employees have a number of investment options to lead a better life after retirement.
How 401(k) Plans Work?
401(k) plans were designed by the United States Congress to encourage Americans to save for retirement. Among the benefits they offer are tax savings.
In general, there are two options with distinct tax advantages:
Traditional 401(k)
401(k) plans deduct employee contributions from gross income, meaning the money comes from payroll before income taxes are calculated. As a result of the employee’s contributions for the year, his or her taxable income is reduced. Contributions are tax-deductible for that year. No taxes are due until the employee withdraws the funds, usually when they retire.
Roth 401(k)
Contributions are deducted from employees’ after-tax income, which means they come from their paychecks after income taxes are deducted. As a result, there is no tax deduction in the year the contribution is made. The employee’s contribution and investment earnings are not subject to additional taxes when withdrawn during retirement. Several employers offer Roth accounts. If a Roth account is offered, employees can choose between them or mix them, up to annual limits on their tax-deductible contributions.
Investing in a 401(k) plan:
The Internal Revenue Service (IRS) sets the dollar limits for employee and employer contributions to 401(k) plans. To qualify for a defined contribution plan, an employer must offer a defined-benefit plan in the form of a pension plan. With a pension, the employer is committed to providing the employee with a guaranteed income level for life.
401(k) accounts also allow employees to choose specific investments from a selection offered by their employers. Most companies offer stock and bond mutual funds and target-date funds designed to minimize investment losses as employees approach retirement.
Contributing to Both a Traditional and Roth 401(k):
When their employer offers both types of 401(k) plans, employees can put some of their money in a traditional 401(k) and some in a Roth 401(k). However, the total contribution to both can’t exceed the limit for one account.
Taking Withdrawals from a 401(k):
401(k) retirement plans make it difficult to withdraw money without paying taxes. “Be sure to save enough on the outside for emergencies and expenses you may encounter before retiring,” says Dan Stewart, CFA, president of Revere Asset Management Inc., in Dallas.
Required Minimum Distributions:
Traditional 401(k) account holders must begin taking minimum distributions at a certain age. The IRS requires account owners who have retired to withdraw a specified percentage of their 401(k) plans after the age of 72, based on their life expectancy at the time.
