Benefits of 401(k) Plans
What Is a 401(k) Plan?
A 401(k) plan is a type of savings account that allows employees to save on their own (up to certain limits), and pay lower taxes because all 401(k) accounts are taxed before contributions.
Deductions for these plans are commonly made pre-taxed, while deposits into traditional or Roth IRA’s are deposited post-taxed. 401(k) plans usually make a matching contribution in addition to whatever the employee contributes.
How Does 401(k) Work?
401(k) plans typically provide a selection of investments, including stock and bond mutual funds and money market accounts. Once an employee has opened up a 401(k) account, he or she can decide how to invest the money in his or her 401(k).
The Benefits of Getting a 401(k) Plan
401(k) plans offer benefits to participants. Some employers match 401(k) contributions, which can be a terrific incentive for employees to increase their 401(k) contribution levels.
401(k) Plans Are Tax-Advantaged Accounts
401(k) plans are tax-advantaged accounts because the money that has been contributed is deductible from current income taxes.
Employees can also control how much they contribute to their plans, and the contributions are taxed at the time they are made.
401(k) Plans Encourage Saving for Retirement
401(k) plans encourage people to save more toward their retirement.
The money that is contributed into the accounts can be deducted from an employee’s taxable income, and this helps lower his or her taxable income.
401(k) plans also allow employees to defer investing until their retirement years, rather than having to use their income for investments now.
401(k) May Lower Your Tax Bracket
Some 401(k) plans let you contribute more money into a plan if your taxable income is reduced during the year.
401(k) plans provide you with an option of creating a 401(k) within your 401(k) so that the money you contribute is not subject to taxes.
401(k) Plan Has More Flexible Options for Contributions
401(k) plans are built on certain assumptions, which include that employees are paid twice per month or 24 times per year.
401(k) plans can be adapted to fit an employee’s pay schedule, which means that the participants don’t have to wait for their next paycheck to put money into their accounts.
401(k) participants may contribute as little or as much as they want, and they can divide the contribution over a number of paychecks if they want.
401(k) participants can also specify how much of their contributions go to pre-tax and post-tax accounts, which means that 401(k)s can fit both high and low incomes.
401(k) Plans Give You the Option of Choosing Your Own Investments
401(k) plan participants have the option of choosing 401(k) investments, which means that plans can adapt to any participant.
401(k) plans allow you to change your investments as often as you want within certain guidelines. 401(k) plans also provide more investment options than some other types of retirement plans.
401(k) Plans Can Be a Great Estate Planning Tool
401(k) plans allow participants to treat 401(k)s like wills and leave 401(k) accounts to heirs for tax purposes.
401(k) account balances that pass onto loved ones at death are not taxed. Plan participants can also choose beneficiaries, which helps them provide 401(k) accounts to heirs.
401(k) Plans Offer a Variety of Investment Options
401(k) participants have the option to invest in 401(k)s through different types of investments.
Some 401(k) plans are called matching 401(k)s, 401(k)s with profit-sharing or 401(k)s with 401(k) accounts. 401(k) participants have the option to invest 401(k) money in 401(k) plans through stock and bond mutual funds and money market accounts.
401(k) Plan Allows You to Take Loans From 401(K) Accounts
401(k) participants have the option of taking 401(k) loans, but 401(k) plan loans must be paid back within a set time period.
401(k) plan loan terms vary from plan to plan, and plan participants may borrow money from their accounts to use for almost any purpose. Plan participants can also pay loans back with 401(k) money.
401(k) Plans Encourage Better 401(K) Participation
Employers sometimes require 401(k) contribution levels to be a certain percentage of taxable income, and 401(k)s don’t count 401(k) plans as taxable income.
401(k) participants who are required to contribute a certain percentage of their accounts often don’t have working plans, and plans can help employers increase the participation rates.
401(K) Plans Offer More Investment Options Than Other Types of Retirement Plans
401(k) plan participants have the option of choosing investments, which means that 401(k) plans can adapt to any participant.
401(k) plans allow you to change investments as often participants want within the account guidelines. Participants also have the option of choosing investment options like stock and bond mutual funds and money market accounts.
The Bottom Line
Storing money in a 401(k) plan is an excellent approach to prepare for your retirement years.
401(k) plans allow participants to contribute money at any time and allow the participants to change 401(k) account investments easily.
401(k) plans offer contributors more investment options than some other types of retirement accounts, and these plans can be a great estate planning tool. 401(k) plans also encourage 401(k) participation because participants can take loans if they want.
These are just some of the benefits you can enjoy with a 401(k) plan.
401(k) Plan | A Complete Beginner's Guide
The 401(k) retirement savings account got its name from the Revenue Act of 1978, where an addition to the Internal Revenue Services (IRS) code was added in section 401(k). Consequently, 401(k) does not stand for anything except for the section of IRS tax code it was created in.
Traditional 401(k) vs Roth 401(k)
There are two types of 401(k) plans: Traditional and Roth 401(k)s. The traditional 401(k), named after the relevant section of the IRS code, has been around since 1978. With this plan, any contributions you make to the 401(k) account will reduce your income taxes for that year and will be taxed when they are withdrawn. Roth 401(k)s, named after former senator William Roth of Delaware, were introduced in 2006. Unlike a traditional 401(k), all contributions are made with after-tax dollars and the funds in the Roth 401(k) account accrue tax free. Typically, employees can take advantage of both plans at the same time, which is recommended among financial advisors to maximize retirement savings. Because of the way the contribution limits work, it is possible to invest different amounts into each account, even year-to-year, so long as the total contribution does not exceed the set limit.
Contributing to Your 401(k) Retirement Plan
Contributing to a 401(k) plan is traditionally done through one’s employer. Typically, the employer will automatically enroll you in a 401(k) that you may contribute to at your discretion. If you are self-employed, you may enroll in a 401(k) plan through an online broker, such as TD Ameritrade. If your employer offers both types of 401(k) accounts, then you will most likely be able to contribute to either or both at your discretion. To reiterate, with a traditional 401(k), making a contribution reduces your income taxes for that year, saving you money in the short term, but the funds will be taxed when they are withdrawn. With a Roth 401(k), your contributions can be made only after taxation, which costs more in the short term, but the funds will be tax free when you withdraw them. Because of this, deciding which plan will benefit you more involves figuring out in what tax bracket you will be when you retire. If you expect to be in a lower tax bracket upon retirement, then a traditional 401(k) may help you more in the long term. You will be able to take advantage of the immediate tax break while your taxes are higher, while minimizing the portion taken out of your withdrawal once you move to a lower tax bracket. On the other hand, a Roth 401(k) may be more advantageous if you expect the opposite to be true. In that case, you can opt to bite the bullet on heavy taxation today, but avoid a higher tax burden if your tax bracket moves up. Check out this article from Forbes to see the IRS tax rate tables for 2020, but remember that they are subject to change. A smart move may be to hedge your bets and divide your contributions between the two types of IRAs. If your employer allows you to add funds to both a traditional and Roth 401(k), then doing so reduces the potential risks of each. In this case, you will also have the ability to decide what proportion of your income goes into each account, meaning that as you near retirement and have a clearer idea of what position you will be in, you can put more into one or the other. When you do decide which avenue to take, make sure to thoroughly evaluate your decision. Moving funds from one account to another, such as from a traditional to a Roth 401(k), is time consuming and expensive, if even possible. Likewise, transferring a 401(k) from one employer to another in the event of a job change is also tricky. You want to make sure that when you put money into your plan, it will be able to sit undisturbed for a very long time.
Pension vs 401(k)
Pensions are similar to a 401(k), but are a liability to a company. If an employer offers an employee a pension, it means that they are promising to pay out a set amount of money to the employee at the time of their retirement. There is typically no option to grow this amount, but it also does not require any financial investment from the employee. Pensions, also referred to as defined-benefit plans, are becoming increasingly rare because it puts the financial burden of offering a retirement fund for employees entirely on the employer. 401(k)s, which are also called defined-contribution plans, take some of the financial pressure off of an employer, while also allowing employees to potentially earn a larger retirement package than they would have with a pension.
How Much Should I Contribute to My 401(k)?
Most financial experts say you should contribute around 10%-15% of your monthly gross income to a retirement savings account, including but not limited to a 401(k). There are limits on how much you can contribute to it that are outlined in detail below. There are two methods of contributing funds to your 401(k). The main way of adding new funds to your account is to contribute a portion of your own income directly. This is usually done through automatic payroll withholding (i.e. the amount that you wish to contribute, counting all adjustments for taxation, is simply withheld when receiving payment and automatically put into a 401(k)). The system mandates that the majority of direct financial contributions will come from your own pocket. It is essential that, when making contributions, you consider the trajectory of the specific investments you are making to increase the likelihood of a positive return. The second method comes from deposits that an employer matches. Usually employers will match a deposit based on a set formula, such as 50 cents per dollar contributed by the employee. However, employers are only able to contribute to a traditional 401(k), not a Roth 401(k) plan. This is especially important to keep in mind if you want to utilize both types of plans. A key variable to keep in mind is that there are set limits for how much you can add to a 401(k) in a single year. For employees under 50 years of age, this amount is $19,500, as of 2020. For employees over 50 years of age, the amount is $25,000. If you have a traditional 401(k), you can also elect to make non-deductible after-tax contributions. The absolute limit, counting this choice and all employer contributions, is $57,000 for employees under 50, and $63,000 for those over 50 as of 2019.
Plan in Advance
401(k) Plan FAQs
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.