What is a 401k?
What Is a 401k, and What Makes It Useful?
A 401k plan is a retirement account when an employee can move a percentage of one’s pre-tax salary to a retirement account. The 401k plan is an employer-sponsored program based on subsection 401k of the Internal Revenue Code. It provides a tax break, plus a person’s employer can match the deposits the employee adds to one’s account.
How a 401k Works
The best way to understand what is a 401k involves looking at how it works. An employee who works for a company that offers 401k support can use these steps:
- When setting up one’s direct deposit account, an employee will set a percentage of pre-tax income to move into the 401k account.
- The employer may match whatever the employee deposits. The rules will vary by employer.
- The 401k account will be invested in a setup that the employer chooses. Sometimes the employee can select what investments one wishes to follow.
- The funds in the 401k account will change in value surrounding the performance of whatever investments are involved here.
- The employee can withdraw one’s funds from the account after retiring.
The employee can also adjust the settings for one’s 401k contributions as necessary. An employer can support the worker’s needs and allow that someone to deposit more or less money from one’s income to a 401k account based on one’s requirements.
The Tax Benefits of a 401k
A 401k plan comes with many tax benefits:
- The employee will not pay taxes on one’s contributions until they are withdrawn after retiring. The earliest retirement age is 59.5.
- The 401k contributions one provides are not interpreted as income. The employee could potentially enter a lower tax bracket, meaning that person won’t have to pay as many taxes in one’s annual return.
- The money in the 401k account will not be taxed while it is in that account. The earnings will be compounded without taxes. The net gains and dividends one earns will not be subject to taxes.
Employer Match Support
One of the most popular 401k benefits involves how a company can match whatever contributions an employer might add to an account. An employer may match the employee’s deposits up to a certain value. The employee can agree to match up to a percentage of one’s contributions in many situations. Sometimes the matching is dollar-for-dollar, but it could also be 50 cents on the dollar in some cases.
For example, an employee can ask to have 5% of one’s pre-tax income moved to a 401k. The employer can contribute the same amount, ensuring one’s 401k account will increase in value faster. The additional funds the employer provides will help the 401k account grow while also offsetting the tax hit that comes when the employee withdraws the funds after reaching retirement age.
Suggested Reading: InvestoPedia Explains 401k Match.
How Much Money Can a Person Contribute Each Year?
The Internal Revenue Service allows people to contribute up to $19,500 in their 401k accounts each year as of 2021. The limit can increase to $26,000 a year for people at least 50 years of age. The increase allows older workers to catch up on their contributions before retiring. Some employers may also have stricter limits surrounding what one can deposit.
What If Someone Moves To a Different Employer?
Another of the 401k benefits to see entails what happens when someone moves to another employer. An employee can move one’s existing 401k account to a new employer through a 401k rollover process. An employer will facilitate the process and transfer the funds in an older 401k account into a new one that follows the investments the new employer supports.
But an employer could also consider doing something else with those funds:
- The employee can roll over the old 401k account to a traditional individual retirement account. The IRA is independent of the new employer, and all contributions are tax-deductible.
- The employee can also move the funds to a Roth IRA, which includes contributions made after taxes. All withdrawals from the Roth IRA are tax-free after retirement age.
- The person could cash out the funds in one’s 401k, but there will be substantial charges. The person will be subject to added income tax, plus there is a 10% withholding fee for whatever funds work here.