If your company offer a 401(k) retirement plan program, it would be good idea to take advantage of it and boost your contributions.
Your company's 401(k) will likely offer a selection of investment options, generally mixes of various mutual funds or index funds.
A plan that consists of a general index fund designed for employees retiring in a certain year range will probably have lower fees than an actively-managed equity fund, for instance.
However, employees who want to have a more active role in their portfolio may be able to choose more targeted funds (technology stocks or U.S. long-term government bonds, for instance).
Benefits of Contributing to a 401(k)
One major benefit of 401(k) plans that some employers offer is matching employee contributions up to a certain extent of the employee's income (up to 4% of annual income is a common percentage).
In that case, the employee should contribute at least as much as that amount to take advantage of what is essentially free money, even if that means reducing contributions to other accounts such as IRAs or general investment accounts.
Another critical benefit of 401(k) plans is that they are tax-deferred investment vehicles, meaning that employees do not have to pay income tax on money that they earned during that year and contributed to their 401(k), reducing their total income tax bill for the year.
Finally, these plans also offer a useful target for retirement savings. Though employees should generally save more than the limits, they provide a specific target savings amount to meet at the minimum annually.
Withdrawals from 401(k) Plans
As 401(k) contributions are not taxed as income in the year that the contribution is made (the amount is deducted on the employee's annual income tax returns), withdrawals are taxed instead.
The tax rate that will apply to these withdrawals is the income tax rate that applies to the account owner during the year of withdrawal. This is generally considered advantageous because most people will have lower taxable income during their retirement years than when they worked, meaning their effective tax rate on the amount withdrawn will be lower.
Owners of 401(k)s must be at least 59½ or be completely and permanently disabled to withdraw the funds in their account without tax penalties.
If they are younger than this age, they will pay a 10% penalty tax on the amount withdrawn in addition to owing normal income tax on the amount.
There are several limited exceptions to this 10% penalty, including the employee's death, qualified domestic court orders, and unreimbursed medical expenses that exceed 7.5% of the employee's Adjusted Gross Income.
Finally, account owners must begin making at least required minimum withdrawals, which are set by the IRS using a life expectancy table, when the account owner turns 70½, unless he or she is still employed.
A 50% penalty is applied on the minimum withdrawal if it is not taken for that tax year.
401(k) Contribution Limits
Maximum employee elective deferral.
Employee catch-up contribution (if age 50+)
Combined employee and employer contribution
Remember, for those with a solo 401k, you can setup your employee elective deferral to be either Roth or Traditional. However, the employer contribution is always traditional.
401(k) plans are a valuable tool to save for retirement, and one that many employees do not fully utilize, especially if their employer will match their contributions.
Annual contribution limits are much higher than those for Individual Retirement Accounts (IRAs) while allowing the same tax-deferral benefits, and they provide an excellent first step for employees to save annually for a secure retirement.
Plus, contribution limits tend to increase each year allowing you to stash away more for retirement.
Do you contribute to a 401(k)? Why or why not?