A 401(k) is a retirement savings plan that the employer sponsors. It allows you, as a worker, to save and invest a piece of your paycheck before taxes are deducted. Taxes are not paid until you withdraw the money from the account.
401(k) plans came to be during the 1980s as a way to supplement one’s pension. 401(k) plans were named for the tax code section that they are governed by. The majority of employers used to offer pension funds, which were managed by the employer, paying out a steady income throughout your retirement. However, as the price to run pension plans skyrocketed, employers started to replace them with 401(k)s. If you hold a government job or had a job with a strong union, you could still be eligible for a pension.
How 401(k) works
With a 401(k) you get to control how your money is invested. Most of the 401(k)s offer a wide range of mutual funds that are made up of bonds, money market investments, and stocks. The most popular trend is to target date funds, which is a blend of stocks and bonds that are slowly converted into more conservative funds as you get closer to retirement.
The 401(k) helps you to save, but there are numerous restrictions that you need to be aware of. In the majority of cases, you are not allowed to immediately tap into your employer’s contributions.
Vesting is the length of time you need to work for the company before you are able to gain access to the company’s payments to your 401(k). It is an insurance against employees that leave early. In addition, there are complex rules about when/how you can withdraw the money, and there are expensive penalties if you pull the funds out prior to retirement age.
Generally there is an administrator hired by the employer to oversee the employees’ 401(k) accounts. They will email you plan updates, aid with requests, and manage the paperwork.
How much should you put in?
So with all that you now know, how much should you put into your 401(k)? Almost every plan offers matching funds, with the 3% of your salary being the most popular.
So how would a 3% match work? If your salary is $50,000 and you put 3% into a 401(k) or $1,500, then your company matches that with another $1,500 into the fund. You could add more than $1,500 yourself, but the company will not match anything over the 3%.
The rules pertaining to matching funds vary, so make sure that you take the time to talk with your employer about the rules and how to qualify for the contributions.
The IRS mandates 401(k) contribution limits. According to the IRS for the years 2007 and 2008, the maximum that you can put into your fund is $15,500, and that can be in any combination of pre/post tax dollars. If you are older than 49, you are allowed to put in another $5,000. The total dollar amount that you can contribute, including a combination of your employers and your contributions, can’t exceed 100% of your salary, so for 2008 that would be $46,000.
You should also think about the type of 401(k) you choose. There are two variants, and the main difference between the two is the tax implications and the schedule for when you can access your funds. It is likely that your company offers a traditional 401(k). The Roth 401(k) is less common. Let’s look at each of these varieties in detail:
You contribute your wages from each paycheck before taxes, like a deferred salary. Your taxable income drops by the amount that you contribute. Upon withdrawal you will pay income tax on contributions and earnings.
You do not have access to your funds before age of 59 or if you leave your employer at age of 55 or older. If you dip into your funds early, in addition to the tax bill, you will have a 10% penalty fee.
Contributions are made with money that has already been taxed. No taxes are paid when you withdraw.
You have more flexibility and free access to your money as long as you have had the account for a minimum of 5 years.
Most companies let you enroll in a 401(k) immediately upon starting employment, although some smaller employers could make you wait up to a year. In those situations, you can set up an individual retirement account, and then file a complaint with the HR department of your employer.
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