What is a 401k and what stipulations should I know about it? Here's everything from the tax breaks to 401k matching and what you should know about them.
If you’re a W2 employee, you’ve probably heard the term 401k thrown around the office. As a matter of fact, you might already contribute to one. But exactly what is a 401k– and what stipulations should I know about it? Below we’ll break down how it works, the benefits, tax implications, and more.
What is a 401k plan and how does it work?
A 401k is a retirement plan offered by employers. It’s an attractive investment option for many reasons. It gives employees a tax break, a chance to boost contributions, and long-term stability.
Employees who choose to contribute to a 401k don’t have to worry about making contributions each month. A selected portion of each paycheck is automatically transferred to the retirement account.
One of the truly unique benefits of a 401k is employer matching. Depending on the size of your organization, your company may offer to match a portion of your contributions. Some companies match 30, 40, or even 50 percent of what you put in.
Let’s say you allocate $500 per month for retirement. Some companies will contribute $250 per month on top of that. Now you’ve got $750 going into a retirement account each month. Not a bad deal.
What is a 401k tax break, you ask? 401k contributions lower your taxable income for the year. If you stash away $15,000 into the account, you’ll only be taxed on your total income from the year after contributions are subtracted. If you earned $80,000 for the year, you’ll only pay taxes on $65,000.
A 401k is also a great long-term investment option because you can take it with you. If you decide to quit your job and move to a new organization, you can roll over your funds.
What’s a Roth 401k?
If you think you might be in a higher tax bracket by the time you reach retirement age, you may want to consider opening a Roth 401k instead of a traditional 401k. What’s the difference?
A Roth 401k is funded with after-tax dollars whereas a traditional 401k accepts pre-tax investments. The Roth option combines different components of a traditional 401k and an IRA. Refer to the IRS to find out if a Roth 401k is the better option for you.
A quick note: If you’re self-employed, a 401k plan may not be the best option for you. It might be beneficial to look into an IRA. IRA’s are typically best for those just starting out or saving less than $5,500 a year. “An IRA is probably the easiest way for self-employed people to save for retirement,” writes Nerdwallet. IRA’s don’t have special requirements and you can open one if you’re a solo operation or have employees.
What is the difference between a pension and a 401k retirement plan?
Unlike a 401k, which requires employee contributions, a pension is fully funded by the employer. Pension plans guarantee a monthly check during retirement. According to Protective, “the 401k will most likely be replacing pension plans altogether in the near future.”
A pension retirement account receives employer-made contributions based on a formula. The equation includes your salary, age, years with the company, and other relevant factors.
Pensions are beneficial because they offer security with a regular monthly payment during retirement. However, these plans are becoming less and less popular because employees are changing jobs more often and they are costly for employers.