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What is a 401(k) plan?
A 401(k) plan is an employer-sponsored savings account specifically for retirement savings. Employees elect how much they want to contribute to their 401(k) plans.
The 401(k) plan gets its name from the tax code that authorizes the plan. As of the 2017 tax year, you can contribute $18,000 each year to your 401(k). If you are 50 or older, you can make a catch-up contribution of $6,000 on an annual basis. Employee contributions are made on a pre-tax basis; this means that a 401(k) contribution decreases the employee’s taxable income and overall income tax obligation. When it is time to withdraw the funds in retirement, the employee must pay taxes on the withdrawal.
After contributing money to a 401(k) plan, the employee decides how to direct the money. Common options include index funds, target date retirement funds, stocks, bonds and money market accounts. You must be 59 and half to begin making withdrawals from your 401(k). Withdrawals prior to this age are subject to a 10 percent tax penalty, unless you have a qualified hardship or meet specific criteria. Ordinary income taxes still are required on the withdrawal.
Your employer also may contribute money to your 401(k) on your behalf. Some employers match a percentage of the employee’s contributions, while others contribute as part of a profit-sharing plan. Some plans have a vesting period before you have access to your employer’s contributions. Your contributions always vest immediately. If you leave your employer, you can roll your 401(k) plan into an individual retirement account.
401(k) plan example
Many employers offer a 401(k) plan as a benefit to assist employees in saving for retirement. Assume that your employer offers a 401(k) plan, and you decide to contribute 10 percent of your annual $55,000 salary. This results in an annual contribution of $5,500. Your employer matches employee contributions 100 percent up to 5 percent of the employee’s salary. In your case, this would be $2,750. Combined, your contribution and your employee’s contribution on your behalf allow you to save $8,250 each year for retirement.
Are you saving enough for retirement? Take a moment to run the numbers.