401(k) plans are a great way to save for retirement
What are 401(k) plans?
401(k) plans are a special type of account that is funded through pre-tax payroll deductions. Money can be placed in the account in various investments, usually mutual funds. It is not subject to taxes on any capital gains, earnings, or interest until the profits are withdrawn.
Tax Benefits and Pre-Tax Contributions
Companies began offering 401(k) plans when Congress passed the Revenue Act of 1978. Income taxes are typically deducted from the money you earn as an employee. A 401(k) plan allows you to avoid paying income tax in the current year on the amount that you put into the plan, up to the 401(k) contribution limit.
Example of Tax Savings
Let’s say you earn $50,000 a year. You decide to contribute $2,500 a year to your 401(k) plan. $104.17 will be deducted from each paycheck before taxes if you are paid twice a month. This money goes into your plan.
Roth 401(k) After-Tax Contributions
Many employers also offer Roth 401(k) plans. You cannot reduce your earned income by your contribution with these plans, but all money grows without paying taxes. You can also withdraw all your money without paying taxes.
Employer Contributions
Many employers contribute to your 401(k) plan. There are three types of employer contributions: matching contributions, non-elective contributions, and profit-sharing contributions. Employer contributions are always pre-tax, so they will be tax-free when you withdraw the money.
When is the Money Yours?
Some types of matching employer contributions are subject to a vesting schedule. The money is in your account, but you may not get any of that money if you leave your job before it is 100% vested. Some companies offer gradual vesting, which means that the employer contributions become yours in increasing percentages based on how long you work. For example, after one year, you have 50% vesting. After two years, you have 75% vesting, and then you become 100% vested after three years. However, you can keep any money that you personally contributed to the plan.
Non-Discrimination Rules
Employers cannot set up 401(k) plans only for themselves or their highly paid employees. The plan must undergo an annual test to ensure it meets these rules, or the employer can establish a special plan called a “safe harbor 401(k) plan,” allowing them to bypass the testing process. Their 401(k) plan will pass any tests as long as they made the required legal contribution, whether as a matching contribution or a non-elective contribution. Any matching or non-elective contributions made by the employer on your behalf are yours immediately with the safe harbor plan.
Investment Options
Most 401(k) plans offer at least three investment options. Many plans set up a default option, such as a specific mutual fund. All the money goes there unless you log in online or call your plan administrator to change it.
Other Rules to Follow
A 401(k) plan must follow several other rules to determine who is eligible, when money can be paid out of the plan, whether loans can be allowed, and when money must go into the plan. You can find a lot of information on the retirement plan FAQ page of the Department of Labor’s website.
Questions
The Trading
How does a 401(k) plan work once you reach retirement? If you are retired and have reached the minimum required by your plan, you are free to withdraw from your account without incurring penalties. The exact process will depend on the company that manages your 401(k) plan, but you can freely sell investments and withdraw funds during retirement as you wish. Withdrawals from regular 401(k) plans will be taxed at your income tax rate. Withdrawals from Roth 401(k) plans are not subject to taxes.
How does asset distribution work in a 401(k) plan?
Not all 401(k) plans offer the same level of freedom in asset distribution as you desire. Some may allow you to rebalance your portfolio from a pre-defined list of investments. Some plans may give you more freedom. There are also plans fully managed by 401(k) companies that do not grant participants any right to distribution. Check with your human resources department to learn more about your options for adjusting your fund distribution.
Source: https://www.thebalancemoney.com/how-401k-plans-work-4135451
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