Finances

The basics of a 401(k) plan: what it is and how it works

A 401(k) is retirement savings and investing plan that employers offer. Employees contribute money to an individual account by signing up for automatic deductions from their paychecks. Depending on the type of plan you have, the tax break comes. Check out!

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by Sabrina Paes

Published on 12/21/2022

Start saving for retirement

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Learn what a 401(k) plan is and how it works. Source: Adobe Stock

Are you wondering what a 401(k) is? The 401(k) is invaluable retirement savings and investing plan that employers offer. Its catchy name comes from the tax code subsection 401(k).

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Employees can choose what fund to invest in from a list of available offerings, with an annual contribution limit of $20,500 in 2022 ($27,000 for those age 50 or older) and $22,500 in 2023. Know more!

What is a 401(k) plan?

A 401(k) plan is a retirement savings plan offered by many American employers. However, this service has tax advantages for the saver and is named after a section of the U.S. Internal Revenue Code (IRC).

When employees sign up for a 401(k), they agree to have a portion of each paycheck paid directly into their investment account.

These contributions can be matched or even fully funded by their employer, who typically offers a variety of mutual funds as potential investments.

It’s an attractive option for many, as participants can reap the rewards of greater returns on their retirement savings than what they could get with traditional savings accounts or other investments.

Benefits

  • The 401k contributions are made on a pre-tax basis, reducing the amount of income tax the employee owes;
  • 401k earnings grow tax-deferred, meaning they are not taxed until they are withdrawn from the account;
  • Withdrawals from a 401k are also subject to income tax, but they are usually taxed at a lower rate than regular income;
  • Many employers offer a matching contribution, which can be an excellent way to boost retirement savings;
  • 401ks often have lower fees and expenses than other investment accounts.

Cons

  • The associated fees for opening an account are relatively high;
  • If you choose to access funds early, you may experience problems or some difficulties;
  • There are few investment options available for your funds;
  • You need to wait until you can keep contributions from your company to pay off;
  • When withdrawals are carried out, there are associated tax implications.

How much can you contribute to a 401(k) plan each year?

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Find out how much you can contribute to a 401(k) plan each year. Source: Adobe Stock

A 401(k) is an appealing retirement savings option that provides tax benefits while allowing you to save for the future. Compared to traditional pensions, such as defined-benefit plans, 401(k)s are especially attractive.

In 2021, the IRS allowed a $20,500 employee contribution limit per year for those under 50 years old. Moreover, it is a $6,500 catch-up contribution limit for those over 50 years old.

This amount keeps growing in line with inflation so that workers can take advantage of more tax deductions in different economic conditions.

Contributing to a 401(k) plan provides benefits such as ensuring financial security during retirement and access to quality investment options.

Starting in 2023, the total contributions an employee can make each year. Moreover, their employer will jump from $61,000 to $66,000 for workers under 50 years old.

Further, for those 50 and over the contribution limit including a catch-up contribution, will increase from $67,500 to allowances up to $73,500.

With these increased limits, employees who have yet to max out their contributions should consider doing so as soon as possible to get the maximum benefits that a 401(k) can offer.

What happens if you leave your job?

Fortunately, you have four options available to ensure your funds are secure. Your first option is to withdraw the money; however, remember that this comes with an early withdrawal penalty.

The second option is rolling your 401(k) into an IRA, the traditional individual retirement account and a popular choice due to its simplicity. The third option is simply leaving your 401(k) with the old employer.

However, this may be necessary if you need to cover short-term expenses and want to leave the rest untouched until needed later.

The fourth option is a relatively straightforward process where you can bring your 401(k) plan and transfer it directly into the new employer’s plan. No matter what course of action you decide, make sure to properly manage your 401(k) program.

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How do you enroll in a 401(k) plan?

Starting a 401(k) plan is the simplest way to begin saving for retirement, and many employers offer them along with an employer-matching program.

Setting up the 401(k) plan is usually handled during onboarding or when paperwork needs to be completed. It is still possible to start a retirement fund even if you are self-employed or own a small business with your spouse.

Solo 401(k) plans, also known as independent 401(k) plans, allow freelancers and other independent contractors to fund their retirement by creating an account through most online broker services.

Investing in a 401(k) plan will enable you to save money efficiently so that your future self has enough funds available when the time comes!

Is a 401(k) plan the best option for your finances?

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Everything you need to know about the 401(k) plan. Source: Adobe Stock

This option is perfect if you have an employer that offers a 401(k) plan. After all, you will have a simpler and more optimized preparation for your retirement.

Additionally, many employers have a generous match associated with them. However, each employer must discuss this condition to determine if this is the ideal option for you.

Alternatives to a 401(k) plan

There are many retirement plans available to choose from in addition to the 401(k) plan. Some of them are the IRA, pension, and deferred annuity. Check out the details!

1) IRA

The acronym IRA means Individual Retirement Account. In this sense, it is a type of savings that you develop yourself and exists in two modalities: traditional and Roth. What differentiates each category is the type of tax collection.

2) Pension

In the case of an employer retirement plan, you might also think about a pension. In this sense, you will receive a fixed monthly amount after retirement, considering the years worked.

3) Deferred annuity

Finally, another interesting option is the deferred annuity. It is a type of insurance that can also be used for retirement. Therefore, you contribute over time and have withdrawals allowed after a certain age.

Thinking about retirement is essential to ensure a healthy and safe old age. Check out the main mistakes when thinking about retirement and learn how to avoid them with the post below.

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About the author

Sabrina Paes

Content Writer, Copywriter, and Ghostwriter. Content marketing professional with 5 years of experience. Specialist in investment, finance, and technology niche. MBA in Marketing at the University of São Paulo, Brazil. Content Writer by Rock Content, and University of California (UCDAVIS).

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