What is a 401k Plan

A 401k is a company/employer sponsored retirement plan that allows workers to take out a portion of money from their daily paycheques, store it on a retirement plan account and earn interest tax-deferred. Tax-deferred means this saved income is not taxable until you withdraw it at the age of 65 or more.

A 401k retirement plan must be sponsored by an employer or an organization. The actual work of administration and monitoring of accounts is usually outsourced to independent banks, mutual fund companies, financial service enterprises and more. As soon as an employee gets a paycheck at the end of the month, he can transfer a portion of it (there are annual limits) to his 401k account. Types of investments available include mutual funds, stocks, bonds, money market instruments (both short and long term).

How is money contributed to a 401k Retirement Account?

– Fixed percentage of paycheck goes directly into 401k account
– Employer makes profit-sharing contributions into the 401k plan
– Employer as an incentive, puts in extra money (on top of the paycheck deduction) into the employee’s retirement account

If an employee quits working with his company, the 401k retirement account still remains active for the rest of his/her life.
Note: After 2004, some companies have started charging fees to administer and maintain your 401k retirement account if you have left their company.

If you leave your current employer and have a 401k account, you can move this account to a professional financial institution. After this, the account changes from a 401k retirement account into an IRA account. However, if an employee quits his former employer and joins a new one, he can do what’s called a 401k rollover to his new company.

Details of 401k Retirement Plans

– In 2020, there is a limit of $19,500 that an employee can put into his 401k account. This is a before-tax amount. For example, say you earn $50,000 a year. You can therefore allocate $19,500 from this 50,000 and put it into the 401k account. What’s your taxable income? $50,000 – $19,500 = $30,500

– Employees who are over 50 years old are allowed what’s called “catch-up contributions.” On top of the original $19,500, >50 years old employees can allocate an additional $6500 per year into their 401k accounts.

– If you contribute more than the set limit ($19,500), the excess amount must be withdrawn by April of the following year. If you do not do so, you will have to pay a certain penalty as well as taxes on the excess amount.

What are the benefits of investing in a 401k retirement plan?

– Your 401k contributions grow tax-deferred up until you withdraw them (upon retirement). This means your dollars grow quicker and tax-deferred. The net effect is that you will have more real dollars working for you.

– You have full control over your retirement savings. You can choose to invest in stocks, bonds, short term money market instruments, etc. This is unlike a pension plan where you are limited in choosing what type of investments best suit you.

– Your yearly current gross income is lesser by the amount of contributions you make. For example, if you earn $50,000 a year and contribute $15000 a year into a 401k retirement plan, your current yearly gross income is $35000. Therefore, you have a current taxable income of $35000 and not $50,000.

– You therefore fall in a lower tax bracket and pay less taxes each year. This means with the power of compounding interest, you have more money working for you in a 401k retirement account.

– 401k retirement plans are portable. This means if you switch jobs and work for a new employer, you can rollover your past 401k plan into an IRA (Individual Retirement Account) or into your new employer’s 401k administration system. You can also withdraw money.
Note: If you withdraw money from a 401k or an IRA before the age of 59.5, you will be subject to pay taxes on the withdrawal and pay an early-withdrawal penalty fee of 10%.

– If your 401k contributions are deducted automatically from your paycheck, you do not have any administration costs (time and money).

– Your employer can also match-up your contributions by a certain percentage. For example, your employer can add an extra 50% of the amount you originally deposit into a 401k plan. For example if you allocate $10,000 a year into a 401k account, your employer will match-up by (50% x $10,000 = $5000). Your total contributions will therefore be:
$10,000 (your money) + $5000 (employer’s money) = $15000

– You can also borrow money in the form of a loan from your 401k account. This “loan” is not subject to taxes and withdrawal penalties. You can pay back the loan automatically through payroll deductions and any loan interest that you pay, will also go back to your account.

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