A 401(k) is an employer-sponsored retirement plan made to ensure that employees have dedicated funds in retirement. It allows employees to dedicate a certain percentage of their pre-tax salary into a retirement account. These funds are invested into a variety or assets such as stocks, bonds, mutual funds, and cash. A set percentage elected by the employee is automatically taken out of each paycheck and invested directly into their 401(k) account. Depending on the specifics of the plan, the money invested may be tax-free and matching contributions may be made by the employer.
401(k) tax benefits are easy to identify because they can offer employees more financial security in the future. Benefits of contributing to a 401(k) include employer matches, tax breaks, and shelter from creditors. A company-matched 401(k) is when an employer offers to match employee contributions up to a set limit.
For example, you make $100,000 a year and your employer offers a match of 50% up to the first 5% you elect to contribute. If you contribute 5% of your annual earnings ($5,000), your employer will contribute 50% of that amount ($2,500). It is up to the employer to decide what percentage they will match regarding your contributions.
Contributions are pre-tax which means you don’t pay taxes on the money until you withdraw to retire (59 ½ years old is the earliest you can withdraw without penalties). Your 401(k) contributions are not counted as income, which would put you in a very low tax bracket. This will result in your tax bill being much smaller compared to investing in a normal taxable investment. Your savings also grow tax-deferred, which means funds grows tax-free if they stay in the plan. If your finances take a bad turn, you will not have to worry about creditors coming for your 401(k). It is protected by the Employee Retirement Income Security Act of 1974 (ERISA) from claims by creditors.
If you happen to change jobs, you have a couple of options including a 401(k) rollover. A rollover is when you transfer your funds from your previous employer to an IRA or to a 401(k) plan with your new employer. You can also cash out your 401(k), but this comes with huge penalties, income tax, and withholding fees. To avoid this, you can wait until age 59 ½ to withdraw the money without incurring a penalty.
Curious where the name 401(k) originated from? It comes directly from a section of the tax code that established this plan – subsection 401(k).