If meeting your retirement goals while getting tax benefits sounds like a great idea, you should consider investing in a 401(k) plan.
What Is a 401(k)?
An employer provides a 401(k) plan as an employee benefit. It offers tax advantages to help employees save for their future retirement.
In a 401(k) plan, employees can contribute a part of their salary to a specific account. Employees receive tax advantages from the amount contributed while also growing their retirement nest egg.
Some things to consider about a 401(k) plan are:
Employee Benefits. A 401(k) plan is a tool you can use as an employee for tax-deferred savings and investments towards your retirement.
Your employer usually matches your contribution and applies it to the designated account. You can choose the amount you decide to invest, and your employer can contribute accordingly. In addition, you can set up your 401(k) plan to automatically deduct a specific percentage of your income so that you continue to build your savings.
The amount transferred, also called deferred wages, is not taxed and is not shown in your income tax return.
Employer Benefits. Employers also receive tax benefits for matching the contributions of their employees' 401(k) accounts. Employers can take deductions on their corporate income tax returns for those contributions.
Investing as an Employee. Although your decision depends on your financial situation, lifestyle, and retirement goals, a typical 401(k) investment rate is about 10% of your salary.
When your employer contributes a matching percentage to your 401(k) fund, you should put in the minimum amount required to maximize your earnings.
If you start investing early, every paychecks' contribution to a 401(k) plan will help you build retirement savings over the long term.
Choosing a 401(k) Plan
There are two primary types of 401(k) plans:
Traditional 401(k). You can contribute a percentage of your salary every month to this plan, which your employer then matches. Sometimes, employers can contribute for the benefit of all participating employees even when they do not contribute to the fund.
Usually, employers provide a matching contribution towards their plan. In addition, employee contributions are eligible for tax deductions.
A traditional 401(k) plan requires an employer to conduct annual tests to verify that they do not discriminate in favor of better-paid employees.
Other plans similar to the traditional 401(k) are:
- Safe Harbor 401(k) plan. Requires the employer contributions to be secured in the fund.
- Simple 401(k) plan. Suitable for small businesses to provide a cost-efficient retirement plan for their employees.
Roth 401(k). A significant difference between a traditional and a Roth plan is that in the Roth 401(k) plan, employees pay taxes on their income before contributing to their plan. That way, they can avoid paying taxes at the time of withdrawal.
Maintaining Your 401(k)
As described, a 401(k) plan is a contribution fund where employees put aside a specific percentage of their monthly income to secure their retirement goals. Employers usually make a matching contribution to the fund.
While you, as an employee, can determine the percentage of income you want to contribute, the maximum amount that both employer and employee can contribute to the fund adjusts for inflation. For 2022, no more than $305,000 of an employee's compensation can be considered when determining contributions.
The employer must report the employee contributions in Form W2 or wage and tax statement even though it is tax-deductible under income tax laws.
Withdrawing From Your 401(k)
You can withdraw funds in both traditional and Roth 401(k) plans only by reaching the age of 59 1/2 years or after meeting specific criteria set by the IRS. In addition, you'll need to consider your vesting percentage because your plan may require the completion of a particular number of years of service for vesting in matching contributions.
If you make an early withdrawal while not following IRS rules, you could receive a 10% penalty on top of the required tax.
In a traditional 401(k) plan, an employee must pay taxes on the amount withdrawn. In contrast, for a Roth 401(k), the employee pays taxes on their income before contributing.
The main benefit of having access to a 401(k) plan is that employees can invest funds for their retirement goals while at the same time getting tax benefits out of it. The employer also pitches in and makes a matching contribution towards the fund to secure the employees' financial future even after retirement.