A 401(k) is a retirement savings plan sponsored by an employer that allows employees to save and invest a portion of their paycheck pretax. This means that before tax is calculated and reduces your gross earnings, a certain amount of money is withdrawn from each paycheck and gets deposited into your retirement account. You do not have to pay any federal or state income tax on your retirement contribution or the earnings you make from your investment until you withdraw the money at retirement. The reasoning is that most people’s tax rate is lower at retirement than during employment, thus they end up paying less taxes.
How 401(k) Works
When you enroll in a 401(k) plan, you need to choose where you will be investing your money. Most plans offer a selection of mutual funds comprised of stocks, bonds, and money market investments. A popular option tends to be target-date funds, a combination of stocks and bonds that gradually become more conservative as you reach retirement age. The amount that you can earn from your 401(k) investments varies based on your investment choices. There are also rules about when you can withdraw your money and penalties for pulling funds out before retirement age, which is 59 ½.
401(k) Company Match
Sometimes, employers will also match or partially match your contributions to your 401(k). For example, your employer may contribute 50 cents to every dollar that you contribute to your 401(k). Some people consider this as “free money” from the employer. However, in many cases, you need to be vested, or work for your company for a certain amount of time before you have “earned” their contributions. This is like an insurance against employees leaving the company early. Your own contributions, on the other hand, vest immediately.
401(k) Contribution Limit
There is a maximum amount per year that an employee is allowed to contribute to his or her 401(k). This amount is set each year by the Internal Revenue Service (IRS). For 2014, the contribution limit is $17,500. If you are age 50 or older, you can contribute an additional catch-up contribution of $5,500, totaling a maximum limit of $23,000.
The 401(k) limit applies to all 401(k) accounts that you might have for the current year. This means that if you have multiple 401(k) accounts, you need to keep track of your 401(k) contributions to all accounts to ensure that you do not contribute over the limit. You can increase or decrease your contributions at any time.
How much should you invest in your 401(k)?
You control how much you should invest and what you should invest in. Many people invest at least enough to get the company match. They don’t want to leave free money on the table. For example, if your company matches 4% of your salary of $50,000, and you contribute 4%, or $2,000, your company will add an additional $2,000 to your 401(k). You can add more than $2,000, but your company will not match beyond that 4%. The rules for matching funds vary, so it is important to check with your employer about qualifying for its contributions. Lastly, don’t forget to elect a beneficiary, or the person who gets your money if you die. If you are married, your spouse is automatically the beneficiary.
What if your company goes under?
Even if your company goes under, your 401(k) is off-limits and will remain safe. You can roll over the money into a traditional IRA to avoid paying any withdrawal penalty.
History of 401(k) Plan
401(k) began in 1978, when The U.S. Congress passed the Tax Reform Act, which included this retirement savings plan for employees. This was passed as a way to encourage employees to save for their retirement using a tax deferred account. 401(k) plan is written under Section 401 Paragraph K of the Internal Revenue Code, which is how it got its name.
Need more convincing? Here are reasons why you should invest in your company’s 401(k).