The defined-contribution retirement plan is a tax break available for mid-income households.
Named after a section of the Internal Revenue Code, 401(k), the employer-sponsored retirement plan is a convenient investment vehicle for employees looking to save for their retirement. Workers can use it to save and invest a piece of their paycheck before taxes are taken out. Your 401 (k) allows your savings to grow tax-free, however, it’s ultimate value depends on several factors — how much you save, how long you have before you retire and how well the stock market performs over that time.
Nowadays, more than 50 million workers actively participate in 401(k) plans, with over half-a-million different company plans in place. Overall, a total of $4.5 trillion in assets is held within all 401(k)s in the U.S.
How does a 401(k) retirement plan work?
The funds are usually taxable only when an employee makes a withdrawal: typically at retirement. In short, the earlier business owners and their employees start saving the better, due to the benefits oIf your employer offers a 401(k), you can opt-in voluntarily and contribute a percentage of your income to the plan. Contributions are automatically deducted from your paycheck, and as pre-tax income. These deferred contributions to a 401(k) are invested in a portfolio made up of mutual funds, stocks, bonds, money market funds, savings accounts, and other investment options.f compounding interest.
The average 401(k) plan offers numerous investment options, and many include additional features such as automatic enrollment and low-cost index fund options.
An employer maintaining a 401(k) plan will generally need to file Form 5500 to report information regarding the qualification of the plan, its financial status and investments.
What are the basic types of 401(k)?
A complete breakdown of 401(k) plans can be found on the IRS website, but these are the four most common types:
- Traditional 401(k) plan. This is considered the most flexible of the plans and allows employees to make pretax contributions through payroll deductions.
- Safe Harbor 401(k) plan. This plan is similar to the traditional plan, except it mandates that employer contributions be vested as soon as they are made.
- Simple 401(k) plan. Only businesses with fewer than 100 employees can offer this plan.
- Roth 401(k) plan. This plan is funded with post-tax income, so money saved is not subject to any federal or state taxes as long as the investor reaches the age of 59.5 before withdrawal.
Does a 401(k) plan have any limits?
The IRS requires that a 401(k) plan satisfy a whole host of criteria, including but not limited to:
- Contribution limits: The IRS determines annual contribution limits for 401(k) plans. There are two limits: one for employee contributions, and another for overall contributions (including the total of all employees and employer contributions). Employees who are age 50 and older by the end of a calendar year may also make additional “catch-up” contributions up to an amount determined by the IRS.
- Distribution rules: The money inside a 401(k) plan enjoys tax-deferred growth, but withdrawals must meet specific conditions, such as the employee’s retirement, death, disability, or separation from employment. Additionally, if an employee reaches the age of 59.5, or experiences a hardship, as defined and permitted by the plan, they may also withdraw funds.
- Limits for high-income earners: As determined by the IRS, employees whose annual income or percentage ownership in the company meets a specific threshold may only contribute a portion of their earnings. The IRS performs non-discrimination testing (NDT) on 401(k) plans to ensure that these highly compensated employees are not contributing disproportionately more than other employees at the company.
If you have a retirement account through your employer, starting to save and invest in your 401(k) may be easier than you think. With recent developments in technology, a lot of the tedious administrative work around establishing a 401(k) and the paperwork it entails has been dramatically simplified. Check out our online library where you can find both simple and comprehensive 401(k) online enrollment form templates for you and your boss.