What Is a 401(k) Plan?
Named after the federal tax code section that created them, 401(k) plans are voluntary savings programs. Employers provide them, and employees choose to participate in them. When an employee participates, a defined amount is taken out of their paychecks and sent directly to their 401(k) investment accounts (Investment options often include mutual funds, exchange-traded funds, and target-date funds). These contributions are pre-tax, which means they are deducted from your income before your income tax is calculated, thereby reducing your overall income tax. Participation in 401(k)s have risen as pensions have become less common.
401(k) Tax Benefits
The tax benefits of 401(k)s are three-fold. First, as just explained, contributions are pre-tax. You don't pay taxes on the money until you withdraw it when you retire. (At the earliest, this is age 59 1/2) Second, your contributions could put you in a lower tax bracket by not being counted as income. The result: your tax bill will be smaller for your having socked away money for retirement. Third, your savings grow tax deferred. Your net gains and dividends would be taxed in a regular investment account. But in a 401(k) plan, your money grows tax-free as long as it stays in the plan. This allows your earnings to earn earnings – or, as a financial advisor would say, to compound. You'll owe taxes, of course, once you withdraw the money.
401(k) Company Match Benefits
Many employers offer to match employee contributions, either dollar for dollar or 50 cents to the dollar, up to a set limit. They do this to encourage people to sign up for the plan, which, as noted earlier, is voluntary. Company matches are also a good perk for attracting and retaining talent. (The IRS allows companies to set time periods of up to five years before matches are fully vested.) Whatever the company's reason for offering a match, it is free money that you wouldn't otherwise get. And like employee contributions, they are tax-deferred, and the earnings are tax-deferred.
Contribution Limits
The maximum amount that an employee or employer can contribute to a 401(k) plan is adjusted periodically to account for inflation, a metric that measures rising prices in an economy.
For 2021, the annual limit on employee contributions is $19,500 per year for workers under age 50, and for 2022, the limit is $20,500 per year. However, those aged 50 and over can make an additional $6,500 catch-up contribution in 2021 and 2022
Suppose the employer also contributes or elects to make additional, non-deductible after-tax contributions to their traditional 401(k) account. In that case, there is a total employee-and-employer contribution amount for the year.
2021
2022
When you change jobs or retire, you may want to roll over your 401(k) to your new job’s plan or to an IRA. Doing this can be tricky, particularly if your account is large. Contact us now if you’re ready to find an advisor who can help you achieve your financial goals.
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Investment advisory services are made available through NFI Advisors, Inc., a Registered Investment Advisor.
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