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Originally Posted On: https://bonsaifinance.com/personal-finance/what-is-a-401k-plan-and-how-does-it-work/

 

As a member of the working world, you covet the reward of a paycheck. If you’ve been in the working world for a while, you might be already dreaming of retirement.

Most anyone who reaches retirement age will say start saving early. You will want as much saved as possible to retire. And you might be thinking, how can I save and pay my bills too?

If your company offers a 401k plan, you have the answer you need. So what is a 401k plan and how does it work?

401k plans offer the opportunity to start saving towards retirement with every paycheck you get.

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Read on to learn all about 401k plans and how they work.

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What is a 401k Plan and How Does it Work?

A 401k plan is a qualified retirement plan offered by an employer to their employees. It allows employees to put money into the plan directly from their pay.

401k plans are desirable for several reasons. The pay comes out of your paycheck before taxes. It can be withdrawn automatically, so it’s money you never see and never miss.

So, not only do you invest in your retirement, you are getting the tax benefit too. The money invested in the 401K is not taxed until it is taken out later in retirement. There are, however, some tax-free plans too.

Understanding Tax Advantages

There are several ways to take advantage of your employer’s 401k plan is advantageous to you.

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Because you contribute pre-tax, you end up paying fewer taxes currently. For example, let’s say your normal pay for a designated pay period is $850. You want to contribute 3% to your 401k plan. That means that $25.50 will come out of your check and go into your 401k plan. Then you only get taxed on $824.50.

So, the higher the percentage you contribute, the less money you get taxed on now.

If you wanted to save that same amount of money and put it into your own savings or investment account, you would do it after you got paid from it and had already paid taxes on it.  Let’s say you pay 20% in taxes. So, you would need to earn $30.60 to equal the $25.50 you paid pre-tax when contributing via the 401k plan.

You will pay less income tax overall. If you make $50,000 a year. Then you contribute 8% to the 401k plan. You put $4,000 towards retirement. Then you are actually only paying income tax on $46,000, instead of the full $50,000.

Employer’s Part in the 401k Plan

The other big advantage to 401k retirement plans is the money your employer also pays into it. When your employer offers the plan, they will designate their contribution. Many employers will match the funds you invest in your 401k up to a certain percentage.

Every employer is different. But the 401k is what the IRS calls a “defined contribution“. When the employer offers the plan to their employees, the IRS, in order to get the tax advantages, says the employer must define what contributions they will make.

For a new employee, they might match a small percentage up to a certain dollar value. Many companies increase the amount of their contribution as the employee stays working for them longer.

Some companies will do a dollar for dollar match. This means that for every dollar you contribute to the 401k plan, they will contribute a dollar too. So, in the above scenario, if you decide to put 8% percent of your pay into the 401K plan for a total of $4,000, the employer would do the same.

Then at the end of the year, instead of having $4,000 tucked away towards retirement, you now have $8,000.

Contribution Maximums

The IRS does put limits on how much you can put into your 401k yearly. The maximum contribution restrictions are also connected to your age. Here they are for 2019:

• For workers under the age of 50, they can contribute up to $19,000 per year.
• For workers 50 and over, they can contribute up to $25,000. This is because they are “catching up” and are closer to retirement age.
• If employers are also contributing, the maximum combined contribution for under 50 is $56,000. For 50 and over the max is $65,000.

Workers can contribute more than the allotted amounts listed above. They just need to pay the tax on the money before. The amounts increase slightly for 2020 and are set by the IRS based on inflation rates.

Traditional Vs Roth Plans

There are really two types of 401k plans. For all of the above scenarios, we have been covering the traditional 401k plans. This money is contributed to the plan pre-tax. Then you pay the tax on the money when you take it out in retirement. The thinking is that you will be making less money then, so your tax rate will be reduced.

A Roth plan is different based on when you pay the taxes. The Roth 401k plan allows you to pay the taxes when you put the money into the plan. The IRS can’t tax you twice on the same money. So, you would not be taxed later when you take the money out in retirement.

If you start investing money when you don’t make much money, it makes sense to pay taxes early on. Then later when you potentially have more money in retirement, you won’t have to pay the taxes.

This is where a skilled financial advisor comes in handy. They can help you to gauge which 401k plan is going to work best for your wages and retirement outlook.

When Should I Start a 401k Plan?

The sooner you can start a plan, the better. This is especially true if your employer is contributing too. The more time your money sits in the investment, the more opportunity for growth too.

Remember though, 401k plans are not like savings accounts. Once you invest the money, you will not have access to it. Some plans will allow you to borrow against your 401k for making a big investment like buying a house.

They sometimes also offer hardship loans. These can be tricky with your taxes and you want to try hard to avoid that scenario.

Start Investing in Your 401k Plan Today

What is a 401k plan and how does it work? A 401k plan is a great way to prepare for retirement. It saves you money in taxes and gives you the opportunity to grow not only your money but money from your employer.

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