A 401(k) is a retirement investment plan that employers offer to their employees. This plan comes with tax benefits and may include an employer match. Let’s dive into the details of what a 401(k) is and how it works.
What is a 401(k)?
A 401(k) is a retirement savings and investing plan available exclusively through employers. When enrolled in a 401(k) plan, an employee can have a portion of their salary automatically deducted from each paycheck and contributed to the 401(k) account. In some cases, employers may offer to match all or part of the employee’s contribution. The contributed money is then invested in funds chosen by the employee from a list of available options.
Why is it called a 401(k)?
The name “401(k)” comes from the section of the tax code, specifically subsection 401(k), that established this type of retirement savings plan.
What if you don’t have access to a 401(k) plan?
For those without access to an employer-sponsored 401(k) plan, exploring Individual Retirement Accounts (IRAs) is a viable option in the realm of budget & finance. IRAs present advantages like a wider array of investment choices and typically more affordable fees. Nevertheless, it’s essential to be aware of drawbacks such as lower contribution limits and constraints for high-income earners. Integrating both a 401(k) and an IRA into a holistic retirement plan is a feasible approach for comprehensive financial management.
Pros and Cons of 401(k) Plans
Pros:
Employer Match: Some employers offer a matching contribution to the employee’s 401(k), providing additional funds for retirement savings.
Ownership of Contributions: The money you contribute to your 401(k) is yours. If you change jobs, you can take your 401(k) with you and either roll it into your new employer’s plan or transfer it to your own IRA.
Cons:
Employer Dependence: 401(k) plans are offered by employers to their employees. If you are self-employed, you may need to explore alternatives like a solo 401(k) with an online broker.
Limited Investment Options: The investment options within a 401(k) depend on the employer’s
plan provider, and individuals may need to manage their investment strategy.
How Does a 401(k) Work?
A 401(k) automates the process of saving for retirement and simplifies investing. The key steps involved in how a 401(k) works include:
Automatic Contributions: Contributions are deducted from the employee’s paycheck automatically.
Employer Match (if applicable): Some employers match a portion of the employee’s contribution, providing additional funds for retirement.
Investment Choices: Employees can choose from a list of investment options to allocate their contributions.
Tax Advantages: Depending on the type of 401(k) plan chosen (Traditional or Roth), there are tax advantages related to contributions and withdrawals.
Traditional 401(k) vs. Roth 401(k)
Traditional 401(k):
Contributions are made with pretax income, reducing taxable income in the current year.
Taxes are deferred until withdrawals are made in retirement.
Both contributions and investment growth are subject to income taxes upon withdrawal.
Roth 401(k):
Contributions are made with after-tax income.
Qualified withdrawals in retirement are tax-free.
Contributions and investment growth are tax-shielded within the account.
Both types have rules around withdrawals, and early withdrawals may incur additional taxes or penalties.
401(k) Changes for 2024
The annual contribution limit for 2024 is $23,000 ($30,500 for those aged 50 or older).
Starting in 2025, employers will be required to automatically enroll participants in 401(k) and 403(b) plans, with contributions gradually increasing to at least 10%.
Understanding the details of a 401(k) plan, including its advantages and potential drawbacks, is essential for effective retirement planning. Individuals are encouraged to review and compare different retirement savings options to make informed decisions based on their financial goals.