What is a 401k plan?
Employees can contribute a portion of their wages to individual accounts through a 401(k) element of a qualified profit-sharing plan. Elective salary deferrals are not taxable income for the employee (except for designated Roth deferrals). Employers have the option of contributing to their employees' accounts. At retirement, disbursements, including earnings, are taxable income (except for qualified distributions of designated Roth accounts).
How does the 401k plan work?
The United States Congress created the 401(k) plan to encourage Americans to save for retirement. There are two main choices, each with its own set of tax benefits.
Traditional 401(k) plans
Employee contributions to a standard 401(k) are taken from gross income, which means the money comes from the employee's paycheck before income taxes are subtracted. As a result, the total amount of contributions for the year is deducted from the employee's taxable income, which can then be recorded as a tax deduction for that tax year. There are no taxes due on the money donated or earned until the employee withdraws it, which is usually in retirement.
Roth 401(k) plans
Contributions to a Roth 401(k) are deducted from the employee's after-tax income, which means contributions are taken from the employee's compensation after taxes have been deducted. As a result, no tax deduction is available in the year of contribution. There are no additional taxes required on the employee's contribution or the investment earnings when the money is withdrawn at retirement.1
However, Roth accounts are not available at all employers. If the Roth is available, the employee can choose one or the other, or a combination of the two, up to the yearly tax-deductible contribution limitations.
What are 401k plan benefits?
401(k)s offer workers a lot of benefits, including:
1. Tax breaks
The tax advantages of a 401(k) start with the fact that you make pre-tax contributions. This means you can deduct your contributions in the year you make them, lowering your taxable income.
Your 401(k) earnings grow tax-deferred, which adds to the benefit. That means the dividends and capital gains that build in your 401(k) are tax-free until you start taking distributions. If you'll be in a lower tax band in retirement (when you take money out) than when you make the contributions, the tax treatment can be a big benefit.
2. Matching 401(k) Contributions
Some companies may match the amount you put into your 401(k) plan. Some also include a profit-sharing provision, in which a percentage of the company's income is contributed to the pot. If your firm gives one or both of these benefits, take advantage of them—they're effectively free money.
Here's how those employee benefits can help you. Many employers will match up to 50% of the first 6% of your 401(k) contributions (k). Let's say your annual salary is $45,000. Your company will match 50% of your 401(k) contribution if you contribute 6% of your annual earnings ($2,700). That's $1,350 in free cash.
Some businesses even go one step further and match your payments dollar for dollar up to the first 6%, which in this case would add another $2,700 to your annual contributions, effectively doubling them.
3. 401(k) Plans Contribution Limits
A 401(k) allows you to save far more money each year than an IRA. The 401(k) contribution limits for 2020 and 2021 are $19,500 and $26,000, respectively (including a $6,500 catch-up for individuals 50 and over). This amount climbs to $20,500 in 2022, plus the $6,500 catch-up. 4
Your employer may also be able to help. The contribution limit in 2021 is $58,000, or $64,500 (with the $6,500 catch-up), while the limit in 2022 is $61,000 plus the $6,500 catch-up sum.
4. 401(k) Contributions Plan After 72 Years
Even if you're still working, you won't be able to contribute to some retirement plans once you turn 72. That implies that any money you contributed before taxes will be taxed at your current rate. And it'll almost certainly be higher than the rate you'll pay once you retire.
401(k)s, on the other hand, do not have this disadvantage. You can keep contributing to these as far as you're still employed. Even better, if you own less than 5% of the company where you work, you can avoid getting mandatory distributions from the plan while you're working.
5. Creditors' Protection
It's beneficial to have your money in areas where creditors can't get to it if you get into financial problems. 401(k)s, as it turns out, provide great creditor protection. This is because the Employee Retirement Income Security Act (ERISA) governs pension programmes, and ERISA accounts are normally protected from judgement creditors. 7
401(k)s also provide some protection against federal tax liens, which are government claims against a taxpayer's assets due to unpaid back taxes. The IRS finds it difficult to impose a lien on a 401(k) plan since it legally belongs to your employer rather than you. Depending on the language in your account's fine print, your plan administrators may be able to refuse to comply with an IRS request altogether.