A 401(k) plan enables employees to defer receiving and paying taxes on a share of compensation. The salary reduction quantity is deducted from the employee’s paycheck and contributed to a retirement fund, where it accumulates earnings tax-deferred till it is distributed. Tax-deferral is advantageous in that it reduces the employee’s annual tax liability, and pre-tax contributions to retirement accounts develop faster than post-tax contributions due to the effect of compounding.
To motivate employees to participate in an enterprise 401(k), many employers make contributions to employee plans in addition to the employee’s contribution. The employer may additionally make automatic contributions to all employee plans, or fit employee contributions to individual plans. Employer contributions are from time to time subject to a vesting schedule, meaning the worker must stay with the organization for a certain period of time to have declared to the employer’s additions. In 2009, employees can contribute up to $16,500 to their 401(k) plan, and persons over the age of 50 can make an additional “catch-up” contribution of $5,500.
Employees should word that an employer 401(k) is not funding in and of itself. A 401(k) is only an investment car that grants tax deferral, so employees have to invest in stocks, bonds, money market funds, and mutual dollars within the 401(k). An average 401(k) has about 20 funding options from which an employee may also choose.
Employees should only contribute long-term investment funds to their 401(k). With solely a handful of exceptions, funds are withdrawn from a 401(k) before the worker reaches age 59.5 will be subject to a 10 percent penalty. Income taxes are deferred till the money is withdrawn, at which time the funds will be taxed as normal income. Once investors reach age 70.5, they are required to start taking required minimum distributions (RMDs) from their 401(k)s. This enables the federal government to accumulate tax revenue from the deferred funds.
After leaving an employer, how long can a company hold your 401k, an employee has several options as to what to do with a 401(k). If desired, the 401(k) can stay intact, and it will proceed to grow tax-deferred until distributed. Frequently, an employee’s great option when leaving an employer is to roll the 401(k) into an IRA, which opens up a world of funding options and makes record-keeping simple.
In 2006, Roth 401(k)s became available, though employers are not required to offer these plans. Employees do now not receive a tax deduction for contributing to a Roth account, but all the cash is tax-free upon withdrawal. If an employee believes he or she will be in a lower tax bracket now than when the money is withdrawn, a Roth account would be a valuable option.