Since it was created in 1978, the 401k plan has become one of the most popular retirement options in America. A huge amount of workers depend on money invested in 401k plans. Providing for them during their retirement, many employers use 401k plans as a major benefit to attract prospects to a job. There are few other plans that can match the flexibility of a 401k.
To take advantage of this type of plan, however, you need to understand exactly how it works. Below are some 401k basics - and some more detailed info - on what you need to know.
A Few Quick 401k Basics
401ks are plans for retirement savings that let employees put a part of their salary into a long-term investment. Employees can also match the employer's contribution to a point. This is a retirement plan that is qualified. A qualified retirement plan means it is eligible for IRS benefits under their guidelines. Two types of accounts in particular offer different benefits for employees:
- Investments of pre-tax money. This money takes a deduction from a gross salary every time an employee is paid. Employees do not have to pay income taxes on this money until its withdrawal post-retirement.
- Investments of post-tax money. There is another account known as a Roth IRA which means an employer has to pay income tax straight away every time they add money to it. After retirement, this money can be taken out and requires no more taxes and contributions. Not every employer offers this option.
Defined Benefit Plans
Plans that qualify come in different variants. These can be either defined contribution or defined benefit; alternatively, they can be pension plans. The 401k falls under the defined contribution plan. What this plan means is that any balance available in accounts are determined by the contributions made to such plans.
The performance of investments can also be a factor. Employees have to make contributions, and an employer can choose to match that contribution or not. After the employee is retired, the balance is in control of the employee entirely. As of 2019, about half of all employees contributed to plans, averaging around 3% of the unemployed salary.
Many employees choose to match $.50 on each dollar that their employer contributes, although there is a limit to this. The maximum amount that taxes can be deferred on the 401k plan is $19,000 for this year. Those who are aged 50 and over can also add catch up contributions of $1000. However, some employers will not match this at all. This part, in particular, is a key factor in the growth of the 401k plan and alternative to a defined benefit plan.
Contribution Limit Of 401k Plans
401K investment options for joint contributions by employers and employees is $56,000 for this year. If your age is 50 or above, this contribution is raised to $62,000.
401k Investment Options
Companies offering for 1K plans give employees the choice of a few different investment options. The top options are managed by advisor groups for financial services. This is going to be groups such as The Vanguard Group or Fidelity Investments. Employees have a choice of various funds to invest their money into. One of these options is mutual funds.
Such funds can include index funds, small or large funds, foreign funds, real estate, and bonds. This ranges from aggressive growth to more conservative types of investments.
Distribution for 401(k) plans is somewhat different for those that apply to IRAs. Regardless, early withdrawal of assets from either plan will incur income taxes. With only a few exceptions, a 10% tax penalty will be added. IRA withdrawals do not need explanations, but rather an event to trigger a payout for a 401k plan needs to be present -
Triggering events include:
- The employee chooses to retire from work or leaves for another reason
- The employee passes away or becomes disabled
- The employee gets to age 59½
- The employee goes through hardship as defined under the plan
- The plan is terminated
This is different from other types of retirement accounts. Even an employee will be required to take the minimum distribution from that additional IRA. When withdrawn from, a 401k is generally taxed as standard income.
Many people that retire transfer the balance from 401k to a regular or Roth IRA. Using this rollover lets them get around the somewhat limited choices of investments that 401k often present. In deciding to do a rollover, it has to be done correctly. With direct rollovers, money is moved straight from an older account to a new account.
With this, there are no tax implications. Indirect rollovers involve the money being sent to the recipient first and then having to pay full income tax on the balance. 401k plans including employer stock let employees take advantage of the NUA rule. The NUA role enables you to capital gains on earnings that can lower your tax bill by a fair margin.
Loans From 401K Plans
At the discretion of your employer, you may have the ability to take a loan from yourself i.e your 401k plan. If allowed, 50% of the investing balance can be taken from your 401k, with a $50,000 limit. Any loans taken must be paid within five years. Longer repayment may be allowed for those purchasing homes. Interest rates on such loans are comparable to rates charged by lending institutions for similar purposes. That's something to watch out for.
Using 401K To Your Advantage
Knowing some 401K basics can bring some definite benefits for you and your family, especially when looking to set up a nest egg for the latter stages of your life. Of course, there are a variety of factors to consider and rules to be aware of when starting your 401k plan. However, don’t let this deter you.
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