401(k) Overview

April 20, 2023

Many employees are hard working individuals looking forward to their golden years of retirement. Although the term 401(k) is extremely familiar to hundreds of thousands of workers all over the country, very few take full advantage of it and even fewer fully understand what it is. At its most basic level, a 401(k) is a tax shelter for retirement savings. While most comprehend this, few understand the full potential of it and how it can make your golden years your best yet. This is why the following list of common questions about a 401(k) has been assembled.

What Is A 401(k) Plan?

A 401(k) plan is a tax-advantaged retirement plan some employers offer their employees. One of its advantages is being able to contribute money to a plan with before-tax dollars that can then be used to purchase a select number of securities defined by your particular plan. The idea is an individual contributes throughout their entire career so when it comes time to retire, there is enough in the account to do so comfortably. This is largely based on the securities within your particular plan appreciating over time. Because retirement is usually thirty-five to forty years away for most first time 401(k) holders, there is plenty of time for these assets to appreciate and gain in value. A 401(k) plan is different from regular investments because regular investments can be taxed in the year interest or capital gains are realized. A 401(k), on the other hand, delays the payment of tax many decades down the road. It is important to note a 401(k) is not mandatory, though it is usually in someone's best financial interest to do so.

Continue reading to learn about investment selection in a 401(k).

Investment Selection

One of the first things to consider when looking at your 401(k) plan is that not all 401(k) plans are the same. Depending on your employer, certain funds or ETFs may or may not be available within the 401(k). So to better understand each of the available investments in your retirement plan, it is a good practice to review each of these funds to see what they truly entail. Many funds are made up of thousands of individual stocks and bonds and knowing what these securities are helps you become a more informed investor. The second thing to consider when selecting investments is what your risk tolerance is. Some investors are willing to take more risk in their investments for the possibility of higher returns, while others are perfectly fine with taking potentially lower returns for less market volatility. Once you properly understand the investments available and determine your risk tolerance, you are ready to allocate the funds in your 401(k) to specific investments.

Continue reading to learn about 401(k) plan contribution limits.

Contribution Limits

Future retirees cannot make unlimited contributions to their retirement account, unfortunately. In 2018, the contribution limit for those under the age of fifty is 18,500 dollars. This number is reevaluated each year and can either rise or stay the same based on the economic climate of the country. For those still in the workforce after the age of fifty, they can contribute up to 24,500 dollars annually to their 401(k). This is designed to help them 'catch up' on retirement savings when they are only fifteen years or so away from retirement. If you account for an employer match, the maximum possible contribution to a 401(k) is 55,000 dollars as an employer can contribute up to 36,500 dollars as part of a matching program.

Continue reading to learn about the relationship between 401(k) plans and taxes.

Taxes

Tax deferment is the main reason individuals opt into a 401(k) plan. The basic premise is that all contributions to your 401(k), whether they are from your own pre-tax dollars or a company match, are not taxed when they go into the retirement account. Then, upon retirement, you pay tax on the withdrawn income based on the income tax bracket it placed you into. Additionally, any contributions made to your 401(k) can be deducted from your tax liability in that fiscal year. This can potentially take you and your family into a lower tax bracket, which means less of each dollar you earn must be paid in tax. There is some risk involved with delaying payment of tax as there is the uncertainty of what the income tax bracket rates will be a few decades down the road. This is because withdrawals from a 401(k) will be subject to future and possibly unknown tax rates. Assuming tax rates remain relatively stable, however, a 401(k) is highly advantageous to all employees to whom it is offered.

Continue reading to learn about employer contributions to 401(k) plans.

Employer Contributions

Another great advantage of an employer-sponsored 401(k) plan is the possibility of a contribution match. It is usually designed to match contributions up to a certain percent of pre-tax income. For example, some businesses may offer a match up to the first six percent of income contributed to the plan. This means if someone making 100,000 dollars before taxes contributes 6,000 dollars per year to their 401(k), the employer will also contribute 6,000 dollars to the account. The most an employer can contribute to a 401(k) plan is 36,500 dollars, which is almost double the amount individuals can contribute themselves. Most financial advisors recommend to, at a minimum, contribute enough to your 401(k) to fully capitalize on the employer contribution match. Any amount contributed that is less than this figure is literally leaving money on the table. Those who fully take advantage of a 401(k) and all of the associated perks are usually most financially secure in retirement.

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