One of the most common ways people save for retirement is by contributing to a 401(k) plan. Put simply, a 401(k) is an employer-sponsored retirement plan that offers big tax advantages, among other benefits.
For the majority of people, it's these distinct benefits that make contributing to a 401(k) a more attractive option than simply investing in individual retirement plans (IRAs). But what exactly are these benefits?
The name 401(k) comes from the section of the IRS code that sets out the rules for this type of account (section 401, and subsection k). In essence, this section details how the US government allows companies to offer retirement savings accounts with certain tax advantages.
If employees want to participate in the plan, they set an amount or a percentage of their paycheck that will automatically be paid into the account.
One of the main benefits of participating in a 401(k) is that contributions are made on a pre-tax basis. This means that contributions are deducted from your income before tax is applied, thereby reducing the amount of taxes you'll pay that year. There are limits on how much you can contribute on a tax-free basis, and in 2020, this limit stands at $19,500 for regular contributors (more on this later).
Another key benefit is that because your contributions are not considered part of your income, you could potentially be put in a lower tax bracket, and therefore have a lower tax bill.
Lastly, with a 401(k), your money can grow tax-free. You can lower your upfront tax-burden, and also allow your money to grow tax-free for as long as it remains in the plan. This allows your money to compound while it stays in your account. You only have to pay taxes on the money when you withdraw it at retirement.
You may have heard company matching referred to as "free money", and this is an apt description. Many employers will match employee contributions up to a set limit. There are two common types of matches; partial matching, and dollar-for-dollar matching.
As the name would suggest, partial matching is when the company matches part of your contribution up to a certain amount. For example, they might provide 50% of what you put in up to 6% of your salary. Dollar-for-dollar matching can be thought of as a "full-match" where the company will put in the same amount you do.
Many people didn't start contributing to their retirement early in their career, but with a 401(k) plan, these people are allowed to catch up. While the limit for tax-free contributions is set at $19,500 for regular savers, most people over 50 are allowed to contribute an additional $6,500 a year (a total of $25,000 per year).
● 401(k) plans fall under the Employee Retirement Income Security Act, which means employers have to ensure that your best interests are served. This adds a layer of accountability not always present with IRAs.
● While withdrawing from your 401k) early can incur a 10% penalty fee, many employers offer more flexibility. Some employers will allow employees to borrow money from their accounts, provided that they pay it back (often with interest).
For the majority of people, investing in a 401(k) is a great way to improve financial security in retirement.