Perhaps you’ve just started working for a company that offers a 401k plan and you need to know how does a 401k work? Or maybe you’ve been avoiding your employer’s 401k plan because you aren’t sure how to make it work best for you. Either way, it’s important for you to take advantage of any retirement plan you have available to you or you could end up without enough money in your golden years.
History of the 401k
The first version of a 401k plan debuted in 1981 to satisfy a law that was enacted by Congress in 1978 to give Americans more encouragement to save money for their retirements. The key component of the law was that participants could save money for retirement while receiving tax benefits at the same time. Initially, this plan was called the Tax Reform Act, but eventually, it became known as a 401k after its section number and paragraph within the IRS code.
Taxpayers were able to begin taking advantage of this section of the code in 1982 and regulations for the plans were published in 1991. They became a part of a family of retirement plans referred to as defined contribution plans. Other plans in this category include IRAs, SEPs, profit sharing plans and money purchase plans. The “defined contribution” part of the plan refers to the fact that the amount that is contributed to the plan is defined by either the employer or the employee.
How Does a 401k Work? – The Basics
There are several differentiating factors that make 401k plans different from other types of retirement accounts. These include:
- As a 401k participant, you tell your employer how much of your paycheck you want to deposit into your account. Usually, you can deposit as much as 15 percent of your pay into your account each month; however, employers can make the limits lower if they choose. The IRS does place limits on how much you can contribute on an annual basis. For 2013, the contribution limit is $17,500.
- Your contributions are taken out of your paycheck on a pre-tax basis. You never even see the amount you contribute to your account, which makes it easier to part with it. Just remember: you will see it again in the future.
- Most employers match some of your contributions with money of their own. No matter how much your employer matches, though, you will want to take advantage of this “free” money. In fact, the minimum amount you should contribute is exactly what your employer matches. So, if your employer will match up to six percent, then you should contribute at least six percent. Otherwise, you are leaving money on the table.
- 401k plans are managed by a third-party administrator who invests the contributions in money market accounts, bonds, stocks and other funds. You can usually choose the funds you want to invest in from a list provided to you by the manager. These funds usually offer a range of options to suit all investors, from safer funds to riskier funds.
Benefits of a 401k Plan
When asking how does a 401k plan work, you will want to learn about the distinct benefits offered to you when you contribute in this type of retirement plan. There are many things to like about a 401k, which is why they are extremely popular amount large and medium-sized companies. Here are some of the reasons why 401k plans are offered by companies all over the country.
- Free money. This is probably the number one reason why employees like 401k plans. As mentioned above, participants’ contributions are typically matched by their employer up to a specific percentage. This matched amount really is free money. It isn’t part of your wages and you don’t really have to do anything for it except save for retirement, which is a good idea anyway.
- Lower taxable income. Because your contributions are made on a pre-tax basis, your take-home pay is actually higher than it would be otherwise. This is due to the fact that the actual income amount on which you are taxed is lower; therefore, the taxes are lower as well. You will have to pay taxes on this money when it is distributed, but that’s many years down the line.
- You can have a bad memory and still save money for retirement. You contributions are deducted from your paycheck with you doing anything except declaring the amount you want taken out. There’s nothing for you to think about once you’ve made your contribution election. Meanwhile, your account will continue to grow.
- Your 401k can effectively replace your income after you retire without any other retirement accounts if you properly manage your 401k.
- You can access your 401k funds in an emergency if necessary. Loans amounting to as much as 50 percent of your vested balance can be distributed if you find yourself in a financial pinch. You will have to repay your loan to yourself with interest, and the amount you have out on your loan will not invested while it is outstanding, but if you can’t get a loan any other way, this is a viable option.
- You don’t have to know much about investing to have a successful 401k. Your money is managed by a professional administrator who knows how to invest your funds appropriately. You do want to keep an eye on your portfolio, but you don’t have to watch your account on a daily basis.
Knowing how does a 401k work is important if you want to take full advantage of your retirement options. The nicest thing about this kind of investment is that your employer pretty much takes care of everything for you. All you have to do is decide how much you want to contribute and where you want to put your money and you’re done. Sit back and watch your retirement funds grow.
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