If you’re looking for a tax-advantaged way to build wealth for the future, one of the most attractive accounts out there is the 401k.
Many employers offer a 401k plan, so there’s a good chance you’ve already heard of this retirement account.
And if you set up your benefits so that you automatically contribute from your paycheck, you can build your nest egg without even thinking about. You might not even miss the money. Yet it will be working on your behalf.
Still not sure if this is the best retirement plan for you? Let’s dive in for a closer look.
What is a 401k?
For most people, the 401k is a tax-deferred account. This means you contribute money before your taxes are taken from your paycheck.
Additionally, a 401k acts as a tax deduction. So you end up with a lower tax bill because you are taxed on a smaller amount of money.
You don’t get out of paying taxes, though. Later, during retirement, when you withdraw money from your 401k, you pay taxes on the distributions.
And if you work for a public school or a tax-exempt organization, you might end up contributing to a 403b plan. This account is similar to the 401k and even has the same contribution limits.
Setting up your 401k through work
For the most part, the 401k is designed to be a workplace benefit. Your employer usually offers the retirement plan and arranges for its administration.
You normally then go through human resources to set up your benefits. Some companies even have you set up your plan as part of your new employee onboarding process.
While you’re filling out your W-4 and completing other paperwork, you might also be asked how much you want to withhold for your 401k.
Other employers require you to work for a certain period of time before signing you up for your 401k account. For example, you might wait 60 or 90 days before setting up your 401k plan.
No matter how long it takes, you’ll need to visit with your human resources representative to find out your options.
In many cases, your employer already has all the necessary information for establishing a plan from your hiring paperwork. You just need to decide how much money you want to be withheld from your paycheck.
401k: don’t leave free money on the table
One of the biggest advantages of participating in an employer-sponsored 401k plan is the possibility of a match.
As an incentive to encourage you to save, your employer might match a percentage of your contributions to your retirement account. This is essentially free money that helps you build your nest egg faster.
Employers usually choose a formula for making matching contributions. There are two main formulas for determining a 401k match:
1. 100 percent match up to a percentage of your income.
In this scenario, your employer will match you dollar for dollar, up to a certain amount.
Say your employer offers a 100 percent match of up to 3 percent of your annual income and you make $50,000 per year. This means that every dollar you put into your 401k account is matched until the employer has paid 3 percent of your income. Or, $1,500.
You can still contribute more, but it won’t be matched. So if you decide to contribute $4,000 a year, your total contribution will be $5,500 because of what your employer put in.
2. Partial match with a maximum limit.
With this option, your employer matches a portion of your contributions until you reach a certain percentage of your salary. In this scenario, your salary determines the upper limit for contributions eligible for the match.
Say your employer will match 50 percent of your contributions that equal up to 6 percent of your income. The annual contribution eligible for matching when you have a salary of $50,000 is $3,000.
However, your employer only matches 50 percent, so the total benefit from the employer is still $1,500.
No matter what the setup is, do your best to get the maximum match available. Free money is free money people.
Each year, the IRS reviews inflation rates and adjusts the contribution limit for the 401k.
Right now, for tax years 2016 and 2017, you can contribute up to $18,000 annually. And for those 50 and over, it’s possible to contribute an extra $6,000 a year as a “catch-up” contribution.
What’s more, with the 401k, you don’t have to worry about deduction phaseouts due to income.
Because the 401k is a tax-advantaged account, you aren’t supposed to start taking distributions until age 59 ½. And when you withdraw your money, it will be taxed at your marginal rate.
However, if you withdraw money before that age, you will pay taxes on the income. Plus a penalty imposed by the IRS.
It is possible to take a loan out against your 401k, too. Some people like this option because it’s not considered an early withdrawal.
Although you pay interest, you usually have five years to repay the loan. However, if you lose your job or switch jobs, the outstanding balance becomes due and you have to pay it back. Otherwise, it’s treated as an early withdrawal.
The 401k is also subject to required minimum distributions. So once you reach age 70 ½, a formula is used to determine how much you must withdraw each year.
Other types of 401k accounts
In some cases, you might have access to other types of 401k plans.
A few years ago, a Roth version of the 401k was introduced. This account has a higher contribution limit, but taxes are automatically taken out of your contributions. So the money grows tax-free, similar to the Roth IRA.
However, the Roth 401k isn’t subject to the income limits of the Roth IRA.
It’s also possible to open a solo 401k if you can find a bank or broker willing to help you go through the process. And, there’s a SIMPLE 401k for the self-employed.
Ultimately, the 401k is a great way for you to save for the future. And even if you don’t max out your 401k contributions each year, it’s a good idea to maximize your employer’s match.
Otherwise, that money just goes to waste rather than into your pocket.
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