Retirement planning

How Do 401(k)s Work?

A 401(k) plan, when properly managed, can pave the way to a comfortable retirement.

At the end of 2021, Americans accumulated $7.7 trillion in 401(k) plans, making them one of the most popular retirement investing options in the country.

What exactly are 401(k) plans, and why are they so popular? Look at this more closely.

A retirement plan that is tax-favored

Many American businesses provide their employees with 401k plans, which are tax-advantaged retirement vehicles. 401(k) is the abbreviation for a provision of the US tax code that deals with retirement programs.

Employees of a company who sign up for a 401(k) plan and consent to having money deducted from their regular paychecks and placed into their 401(k) plan accounts are said to have a 401(k) plan.

Employees who participate in 401(k) plans have access to a variety of investment options for funding their retirement, such as:

  • Indexed funds
  • Date-specific funds
  • Along with particular stocks, bonds, and money market funds, there are mutual funds.

According to the IRS, plan owners are only permitted to contribute a maximum amount to their 401(k) plans each year, which is $20,500 for 2022. In addition to receiving assistance from their employers with matching contributions, employees may invest up to the maximum amount.

For instance, a worker making $50,000 annually might put $5,000, or 10% of that amount, into a 401(k) plan each year.

Additionally, the company could match 100% of the employee’s contributions up to $2,500, or 5% of the employee’s yearly salary. The employee’s total yearly contribution to a 401(k) plan is $7,500. This money can be invested for retirement on a tax-deferred basis.

For Americans 50 and older, the IRS also permits an extra $6,500 annual 401(k) “catch-up” contribution.

Roth 401(k) and traditional 401(k) (k)

An employee can have the option of selecting a Roth 401k plan or a standard 401k plan.

Traditional 401(k) Plan: The most popular type of 401(k), a traditional 401(k) plan enables employees to make contributions to the plan before taxes are deducted, lowering their taxable income.

A Roth 401(k) plan is one that is not treated the same as a standard 401(k) plan for tax purposes. Contributions to Roth funds are made after income taxes have been deducted from an employee’s paycheck rather than from their gross income.

The two strategies vary from the back end as well. A Roth 401(k) allows plan holders to avoid paying taxes on plan withdrawals in retirement, in contrast to a standard 401(k) plan where the employee is responsible for paying taxes on plan withdrawals in retirement.

The IRS permits 401(k) investors to choose a combination of both plans in their employer-sponsored retirement portfolio, but only up to particular yearly restrictions on tax-deferred 401(k) plan contributions. Employees often have a choice between a standard 401(k) and a Roth 401(k).

Withdrawals from 401(k)s

Generally, participants in 401(k) plans may begin collecting distributions from their 401(k) accounts when they turn 59 and a half, or sooner if they are handicapped and meet certain IRS 401(k) plan early withdrawal requirements.

A 401(k) plan participant who borrows money from their plan early and fails to repay it in full and according to a deadline is often subject to a 10% early withdrawal penalty on top of any other taxes they owe the IRS.

Distributions at a Minimum Required

Taxes on retirement savings can be delayed, but they can’t be put off indefinitely. After a certain age, people who have tax-deferred assets like traditional 401(k)s or IRAs are compelled to draw distributions from those accounts each year.

By April 1 of the year they turn 72, retirement savers born after June 30, 1949, must start taking these mandated minimum distributions.

People who were born before July 1, 1949, had to begin taking their required minimum distributions (RMDs) by April 1 of this year. They must take another payout by December 31, 2022, and every year after that, by December 31.

Failure to take the needed minimum distributions carries some serious consequences. Check out the AARP’s RMD calculator.

401(k) Plan Benefits

During their working years, Americans can take advantage of a company-sponsored, tax-advantaged retirement plan through the 401(k) plan.

Holders of 401(k) plans can enjoy the best of both worlds – long-term investing opportunities on a tax-deferred basis and a nice nest egg – with regular investments and matching contributions from employers.

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