What is a 401k Plan
The 401k plan is a type of retirement plan where eligible employees save ahead via deferral or salary contribution to the plan on a post-tax or pre-tax basis. It was initiated in 1978 and has since grown to become one of the most popular employer-sponsored retirement plan in the US. Records show that the plan accounts for about $4.7 trillion of the $24 trillion total US retirement assets. Millions of workers from various sectors of the economy depend on the 401k plan for their retirement years.
How the 401K Plan Works
The internal revenue service (IRS) regulations place a cap on the contribution limit of employee salaries to the plan. Other restrictions include how and when an employee can withdraw the assets. Those who withdraw before they reach the retirement age are penalized. Employees make a pre-taxed contribution to the plan which is an advantage although a tax will be on the withdrawals from the account.
In 2006 a new option of the plan was introduced to rival the traditional 401k plan known as the Roth 401k plan, and it offers participants an option to make after-tax contributions of which the withdrawals are absolutely tax–free as long as you meet the required conditions. In this Roth option, limitations to contribution can be on one’s age say for example; participants up to the age of 50 as of 2015 were limited to $18000 per year, $24000 for those above 50 years. The conditions for the withdrawal of assets include;
- The account must have been sustained for at least 5 years
- The withdrawal must occur on account of death or disability of the account holder or when the account holder reaches the age of 60 years.
Roth 401k V.s Traditional 401k
The major difference between the two is on the taxation and distribution method of the funds. Remember that when the traditional 401k plan is funded, the participant is not taxed instead it is deduced from his/her income returns. But on the other hand, when a Roth 401k plan is funded, the funds will be taxed. Now the reverse becomes the case during distribution or withdrawal. The traditional 401k plan is taxed on withdrawals while the Roth plan is not taxed on withdrawals.
Benefits of the 401k Plan
- Because of the tax reduction benefits of the plan, participants enjoy tax credits and other incentives which reduces costs
- Assets on the plan are tax-free
- Improved financial security on retirement for participants
- Contributions are made through payroll deductions making very easy
- The assets on this plan are movable from one employer to another in case one decides to change jobs.
In conclusion, the 401k plan is very important for good retirement planning. The plan currently has over 50 million workers as active participants making it very popular amongst employees. The plan also enjoys dozens of different investment options thanks to the recent reforms.
Please note that this article is just a step in knowing what it is all about, to get more specific details, contact your employer or plan provider. I hope this article was helpful; please share with your friends and ask any questions on the comments box.