Most American workers can no longer rely on Social Security benefits or company-sponsored pensions to provide a comfortable retirement. As a result, there are many types of private retirement plans to choose from today, with the 401(k) being one of the most popular.
Named after the section of Internal Revenue Service (IRS) code under which it falls, the 401(k) has been available since the early 1980s. The 401(k) plan was created as a way for employers to provide a retirement savings for their employees. It is a type of “defined contribution plan” – so called because the individual’s retirement benefits depend on the amount of money contributed rather than total years of service. Plans differ among various employers, but the basic idea is that employees can contribute a specific portion of their salary each year toward a retirement account, which is managed by an investment administrator and directed toward any number of investments, including stocks, money market accounts, and bonds. The employee exercises a great deal of control over the plan, from choosing how much to contribute to selecting the types of investments. Most types of investments included in 401(k) plans are considered relatively low risk.
Many employers make matching contributions to their employees’ accounts, with amounts varying depending on the employer and the terms of the plan. These matching contributions are one of the best features of a 401(k) plan. Basically, it is free money, which makes for a phenomenal investment, as your retirement savings continues to grow larger and earn more interest – and you don’t have to do a thing! Employer matching contributions also give 401(k) plans an edge over simply investing on your own. Depending on the plan, the employer might make its contributions available under a vesting schedule. While you always own everything you pay into the account, your employer might only make its matching contributions available after a certain time period. Vesting schedules are usually dictated by the third party investment company that oversees the plan.
One of the biggest advantages of a 401(k) is that the annual contribution is tax deferred, which means the employee pays no taxes on the money until it is withdrawn. This results in two types of tax savings: One on the front end of the contribution and one on the back end at withdrawal. First, consider an employee who earns $40,000 per year and contributes $2,000 annually to a 401(k) plan. The employee’s yearly salary for income tax purposes would only be $38,000, which means a lower income tax amount. Second, because annual retirement income tends to be lower than income earned while working, you end up paying less taxes when you withdraw the money at retirement.
Annual employee contributions are capped by the IRS at $17,000 for 2012. The maximum contribution amount changes from year to year based on inflation, typically in $500 increments.
Under current law, you can begin withdrawing money from your 401(k) without penalty at 59½ years of age. If you need to withdraw the money sooner, most plans allow you to take out a loan against your contributions at a reasonable interest rate. Basically, you are borrowing money from yourself, so the interest simply ends up back in your account.
Many people change employers over time, which raises questions about how to handle 401(k) funds. One of the easiest and most effective solutions is to simply roll the money over to another 401(k) plan at the new job. Other people opt to cash out their plans, but this automatically makes the money subject to tax as well as a 10% IRS penalty for early withdrawal. Your best bet is to either direct the money to a new plan or keep it intact with your previous employer.
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