Many employers offer 401k plans to their employees, because they offer a valuable opportunity to make tax-deferred investments. These plans are named after a section of the U.S. Internal Revenue Code and there are two basic types of 401k. The traditional 401k and Roth 401k, which is sometimes called a designated Roth account.
401k plans are defined-contribution plans, which allow employees and employers to make contributions to an account up to a limit set by the Internal Revenue Service. This is the opposite of defined-benefit plans, which require employers to provide a specific amount of money to an employee upon retirement. The money in the account is used to invest in an assortment of stock and bond mutual funds. Other investment vehicles may be included as well.
All 401k plans have a maximum amount of money that can be contributed in any given year. This amount is adjusted annually to account for inflation. In 2020 and 2021, the basic limit on employee contributions is $19,500 per year for workers under age 50. For workers age 50 and up, the limit is $26,000.
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Your employer may also offer to contribute to your 401k fund. If this is the case, the contribution limit is higher. For people below age 50, the total employee plus employer contribution limit is $58,000, or 100% of employee compensation, whichever is lower. For those over age 50, the limit is $64,500. This additional contribution is traditionally based on employer contributions, but it can also include non-deductible after-tax contributions made to a traditional 401k account by an employee.
Many employers set their 401k plans up to provide a match for employee contributions. There are different formulas for how much is given in the match, but a common example would be 40 cents for every dollar the employee contributes. In most cases, it is ideal for employees to contribute at least enough to receive the highest match possible.
A Roth 401k allows you to make contributions after taxes have been taken out of your income. Then, when you withdraw the money, the money is tax free. This is unlike traditional 401ks, which are tax-deferred until you withdraw the money. Deciding between the two types of IRAs takes consideration of how much you will be worth in the future and whether your taxes will be lower now or later. A financial services professional can help you identify which account fits your situation best.
The Benefits of Having A 401k
401k plans allow you to plan ahead for retirement and create a nest egg that can be used to pay your ongoing expenses. Depending on which type of 401k account you choose, your income can be taxed at the point you choose. This can allow you to save significant amounts of money. If you understand the benefits and want to start preparing for retirement now, then now is the time to get a headstart in your financial planning.