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Britt Erica Tunick is an award winning financial journalist who has spent the past 17 years writing about virtually every aspect of finance. She has mastered the art of boiling down complicated financial topics for readers to understand. |
401(k) plans are personal retirement investment plans offered by employers that carry tax benefits for the individual funding them. What is a 401(k)? By Britt Erica Tunick Everyone knows that there’s no such thing as a free lunch, but 401(k) plans are probably the closest thing you’re going to find. Also known as qualified defined contribution plans, 401(k) plans (which get their name from the Internal Revenue Service code that allows for their existence) are personal retirement investment plans offered by employers that carry tax benefits for the individual funding them. But perhaps the most attractive part of 401(k) plans is the fact that many companies have traditionally matched the amount employees contribute to them, up to a specific percentage of an individual’s contribution – most commonly around the 6% mark. For example, if an employee earning $100,000 allocates 10% of their salary to a 401(k) plan ($10,000), a company that matches employee contributions at the 6% mark on a dollar per dollar basis would contribute an additional $6,000 to that employee’s retirement savings, which is arguably better than a free lunch. Like everything government related, however, 401(k)’s have their share of specific rules and regulations, and the specific type of plan that a company offers determines the type of tax benefits employees can recognize from their investments. There are two main 401(k) plan types: The first, known as traditional 401(k)’s, allows employees to contribute pre-tax money that is not taxed until the funds are withdrawn at the time of retirement, or when the individual hits age 59½. The second, known as Roth 401(k) plans, essentially allow individuals to deal with taxes upfront. Unlike traditional 401(k)’s, Roth 401(k)’s require contributions of after-tax dollars, but allow employee to withdraw their money on a tax-free basis at the time of retirement. Though there is no overall limit to the amount of money employees can contribute to their 401(k) plans, other than the fact that the amount cannot exceed their salary, under IRS rules tax-free contributions into traditional 401(k)’s are capped each year at a pre-determined amount set by the government agency. For 2014, employees can contribute a maximum of $17,500 into their 401(k)’s on a tax-free basis – the same limit as last year. Employees age 50 and older can take advantage of what are known as catch-up contributions as well and are allowed an additional $5,500 tax-free contribution in 2014. Much like traditional mutual funds, 401(k) plans are ultimately pooled investment funds where the money employees invest is paired with the investments of other employees and managed within one large investment portfolio. As with mutual funds, individuals that invest in 401(k) plans receive quarterly statements indicating the number of shares they ultimately own of the overall portfolio and the value of their holdings. Similarly, most 401(k) plans allow individual contributors to determine the specific investment strategy, or combination of strategies, they would like their money allocated to – everything from straight-forward equity mutual funds, to bond funds or even a company’s own stock. The options available to a 401(k) contributor vary, based on what their individual employer has chosen. Beyond the tax-benefits and employee matching that most 401(k) plans carry, another benefit for many individuals is the simple fact that the plans provide a long-term approach to retirement saving that is automated and fairly simple. Once contributions are set up the money allocated is automatically removed from an employee’s salary before they are paid – meaning there is no chance of wandering from the ultimate retirement goal by spending that money on something else before it can be saved for retirement. |
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