Published Mar 21, 2024 A 401(k) plan is a tax-advantaged, employer-sponsored retirement savings account for employees. Named after a section of the U.S. Internal Revenue Code, 401(k) plans allow employees to save and invest a portion of their paycheck before taxes are taken out. Taxes aren’t paid until the money is withdrawn from the account, typically after retirement. Employers can choose to match contributions to some extent, which enhances the value of the savings plan for employees. Imagine an employee, Lisa, who earns $50,000 a year. Her employer offers a 401(k) plan with a 5% match. Lisa decides to contribute 10% of her salary ($5,000) to her 401(k) plan each year. Her employer then contributes an additional $2,500 (5% of her salary), effectively giving her $7,500 in total contributions per year. Over time, thanks to compound interest and investment returns within the 401(k), Lisa’s retirement savings can grow significantly. This setup not only helps Lisa save for retirement but also reduces her taxable income since her contribution is taken from her pre-tax salary. 401(k) plans are a critical component of retirement planning in the U.S. They offer several benefits, including tax advantages, employer match programs, and the potential for compound growth over time. By reducing taxable income and offering a structured way to save for retirement, 401(k) plans encourage financial discipline and long-term planning. For companies, offering a 401(k) plan can be a valuable tool for attracting and retaining employees. These plans are a win-win for both employees and employers; they provide a means for employees to save for their future while receiving tax benefits and possible additional contributions from their employer. Contributions to a traditional 401(k) plan are made with pre-tax dollars, which lowers an individual’s taxable income for the year. Taxes on contributions and any gains are deferred until the money is withdrawn, typically in retirement when the individual may be in a lower tax bracket. Roth 401(k) options, where contributions are made with post-tax dollars, are also available in some plans, allowing for tax-free withdrawals in retirement. An employer match is a contribution an employer makes to an employee’s 401(k) plan, matching the employee’s contributions up to a certain percentage of their salary. This percentage varies by employer. The match is essentially free money that adds to the employee’s retirement savings, incentivizing higher personal contributions to the plan. For 2023, the contribution limit for employees who participate in 401(k) plans is $20,500. Individuals aged 50 and older are eligible for an additional catch-up contribution of $6,500, raising their total contribution limit to $27,000. These limits are subject to annual adjustments for inflation by the IRS. If you leave your job, you typically have several options for your 401(k): leave the assets in your former employer’s plan, roll over the money to your new employer’s plan if one is available and rollovers are permitted, roll over into an Individual Retirement Account (IRA), or cash out the account (which may trigger taxes and penalties). Each option has different implications for your retirement savings, so it’s important to choose carefully based on your individual circumstances. Many 401(k) plans allow participants to borrow from their account for specific purposes, such as buying a home, paying for education, or facing financial hardship. However, there are restrictions and potential downsides to 401(k) loans, such as missing out on investment returns and having to repay the loan with interest. Borrowing from your 401(k) should be carefully considered and typically viewed as a last resort.Definition of 401(k) Retirement Plan
Example
Why 401(k) Retirement Plan Matters
Frequently Asked Questions (FAQ)
How do taxes work with a 401(k) plan?
What is the employer match and how does it work?
What are the limits on 401(k) contributions?
What happens to my 401(k) if I change jobs?
Can I borrow from my 401(k) plan?
Economics