If you were ever employed in the US, or you are trying to find employment, you’ve probably heard of the 401(k). But what is this exactly and how does it work?
Here is briefly what you need to know about this retirement plan.
What is the 401(k) retirement plan?
401(k) is an employer-sponsored pension account in which both the employer and the employee make regular contributions. The name 401(k) comes from the subsection of the Internal Revenue Code containing federal statutory tax law in the United States.
Many companies offer the 401(k) retirement plan among the benefits and it’s an easy way to start saving for retirement. Usually, they match the contribution of the employee up to a certain limit. For instance, an employer may match up to 50% of the employee’s contribution, up to 5% of the salary. Offerings may vary but having an employer that offers this benefit is definitely a plus so keep an eye on it on your next job offer.
The contributions you add to the account will accumulate interests over the year which makes this a great option for both saving and investing.
Types of 401(k) plans
Although there are several types of 401(k) retirement plans, they can be divided into two main types:
Traditional 401(k): with this type, your contributions to the plan are not taxed but your withdrawals are. This means you will pay taxes on what you earn minus your 401(k) contribution. When you withdraw money from your 401(k) account, you will pay taxes on that amount.
Roth 401(k): this type is the opposite of the traditional since it takes the contributions but not the withdrawals. With this type of plan, you will pay taxes on all your earnings including your 401(k) contribution but you will not pay any tax on the amount you withdraw from that account later on.
A great benefit of both these retirement plans is that the profits in the account are never taxed.
How to get a 401(k) retirement plan?
Usually, you are enrolled in the 401(k) retirement plan when starting a new job or at the end of a probation period. Depending on the type of benefits the employer offers, they may match a portion of your contributions. These will be deducted from your paycheck and the applicable taxes will be withheld.
If you change employers, you will not lose your 401(k) but you’ll have options to have that money either cashed out or rolled into a new 401(k) plan.
It’s worth knowing that withdrawals before the age of 59½ are discouraged and you will need to pay a 10% early distribution penalty. The exception to this is the “rule of 55” which allows you to withdraw without a penalty if you leave your job, retire, or get fired in the calendar year that you turn 55.
However, having a 401(k) retirement plan is a great idea for your personal finances. Additionally, you may want to start creating an emergency fund or set up a savings account that you’ll always be able to withdraw from in case of need.