What is a 401K?

Many people have heard of 401K programs but may not be entirely sure what they are, how to get one, and then what to do with a 401K once they have one! It’s no wonder that there can be some confusion about different types of savings and investment plans  – since most people did not have a course about it in school, and some employers do not bother to educate their employees about options. However, continue to read on and you will get a clear idea of what a 401K plan is.

 A Tax Free Savings Plan. A 401K plan is a plan that can only be offered through your place of business and is also known as an employer-sponsored retirement plan. This is because the IRS allows special tax breaks to companies and their employees who use a 401K plan to save for retirement. A 401K plan is also called a defined contribution plan as well, because the plan allows employees and employers to contribute specific amounts or percentages of funds into the 401K plan on an annual basis, free from taxation! In other words, your pre-tax dollars go into the plan and can be saved, invested, and accumulated until you retire without any tax payment required. (That is, only if you keep the funds in the account until you retire or to age 59 ½ – early withdrawals will be taxed at regular income tax rates AND penalized at an additional 10 per cent.)

How 401K Plans Work. When you are paid each period, your paycheck will generally be broken down into pre-tax and after-tax payments. The 401K plan is set up so that any 401K contributions are automatically deducted from the employee paycheck and deposited into the 401K account. Remember, this is on a pre-tax basis, which can end up saving you a lot of money for retirement in the long run. Think about it this way – your taxes could be anywhere from 20 to 30 per cent of your gross income – so if you save 401K fund on a pre-tax basis, you are essentially earning an automatic 20 to 30 per cent “return” on your investment right from the start! The money will be taxed when you withdraw in the future, but hopefully by then you are retired and in a lower tax bracket so you are not taxed at rates as high as when you were working full time.

 What are the Advantages of a 401K Plan?

 401K plans are popular for a number of different reasons:

  • Any type of business can set up a 401K plan. (However, depending on the size and scope of your business, there are other savings plans that may make more sense for you. If you are in the position of setting up a 401K plan from scratch, make certain you discuss your options with a financial professional.)
  • The entity that establishes the plan can determine the guidelines for both employer and employee contributions, including setting restrictions on when employees may contribute or when matching funds are fully vested. For example, an employee that has worked for a company less than 1 year could be ineligible to join the 401K plan. Or another example could be that it will take 5 years for an employee to full earn any matching funds the employer may decided to contribute.
  • Each year, the IRS sets guidelines for the amount that can be contributed to the 401K account, and the figure is usually adjusted to keep pace with inflation.
  • Contributing employees over the age of 50 are allowed to make accelerated “catch-up” payments based on IRS guidelines which may change from year to year.
  • One of the best features of a 401K plan is that the contributed funds can usually be invested in a wide variety of choices, such as mutual funds. This means that not only can the 401K funds be contributed on a tax-free basis, but also any gains that are earned via investment will also accumulate tax-free.
Tuesday, March 16th, 2010 Financial Planning, Saving Money

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