The 401(k) is a retirement savings plan offered by an employer that allows employees to allocate a portion of their salaries for the future and take advantage of tax benefits in the process.
How does the 401(k) work?
The 401(k) is available in many workplaces as a benefit for employees. If the employer offers it, it’s worth considering; it is one of the easiest ways to start saving for retirement. When starting a new job, some employees are automatically enrolled in the 401(k) plan. Others may have to wait until a certain period of time before enrolling in the plan.
When enrolling, you can specify a fixed percentage or amount that you want to allocate from each paycheck into your 401(k) account. You can also choose the investments that you wish to place this money into and the percentage you want to allocate to each investment. The distribution of your funds across different types of investments is known as “asset allocation.”
The plan is often managed by the human resources department. If you work traditionally, the employer will deduct your contributions from your paycheck; then, they will direct it to the investments you selected according to your desired asset allocation. However, they do not manage the assets in the plan.
With a traditional 401(k), any contributions you make are excluded from your taxable income in the year of contribution. In other words, they are eligible for a tax deduction in that year. Additionally, contributions and earnings grow tax-deferred. This means you won’t pay taxes until you withdraw the money from the account.
Note: The contributions you make to your 401(k) may sometimes be referred to as “salary deferral.”
Furthermore, some employers make matching contributions to your account. For example, the employer may add $0.50 for every dollar you contribute to the plan, up to a certain amount.
Let’s say Jack earns $80,000 a year. He enrolls in the 401(k) plan offered by his employer and selects a variety of mutual funds. He contributes $5,000 to his 401(k) in a given year through a paycheck deduction. However, he is taxed as if he earned only $75,000 that year; the $5,000 contribution is tax-deferred. This means it is excluded from his taxable income.
The money grows tax-free, so Jack does not pay taxes on his contributions or earnings over time. When Jack reaches age 59 and a half, he decides to withdraw money from his 401(k) account. At that point, he pays taxes on it. His tax rate is determined based on his tax bracket at the time of withdrawal. This may be lower than his rate in years of income.
Tip: Look for the tax-saving investments you receive from pre-tax contributions to your 401(k). This can help grow your portfolio faster.
Types of 401(k)
There are two main types of 401(k) plans, each with unique tax implications.
The traditional 401(k): Also known as the “pre-tax 401(k),” this type allows you to contribute money before taxes. Your contributions are eligible for a tax deduction; and contributions and earnings grow tax-deferred. However, distributions of contributions or earnings are subject to federal and state taxes.
The Roth 401(k): These are 401(k) plans that allow for designated Roth contributions. These contributions are made with after-tax money into a separate Roth account. Roth contributions are included in your taxable income at tax time. However, contributions and earnings grow tax-free. Since you will pay taxes on your income before contributing to your 401(k), you won’t have to pay taxes again on qualified distributions from the account.
Note:
A Roth 401(k) distribution is typically considered “qualified” in certain cases: if the account has been open for at least five years and the distribution is made due to disability; after and
Source: https://www.thebalancemoney.com/what-s-a-401k-retirement-plan-453770#toc-what-is-a-401k
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