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A 401(k) plan is a tax-advantaged retirement savings vehicle provided by employers to help employees save for their retirement. It offers tax benefits, potential employer matching contributions, and a range of investment options.
Eligibility
To participate in a 401(k) plan, an individual must be employed by a company that offers such a plan. Employers may set specific eligibility criteria, such as a waiting period (e.g., three to six months) before an employee can start contributing. Some employers also extend 401(k) benefits to part-time employees.
401(k) plans are also available to self-employed individuals who can make regular contributions to the plan.
Contributions
Employees contribute a portion of their pre-tax income to their 401(k) accounts through automatic payroll deductions. The maximum annual contribution limit is set by the IRS and can change from year to year.
As of 2023, contribution limits are $22,500 for employees, and $30,000 for those above the age of 50.
These contributions are tax-deferred, meaning they are not subject to income tax until they are withdrawn during retirement.
Employer Matching
Many employers offer a 401(k) match, where they contribute money to an employee's 401(k) account based on the employee's own contributions. The employer match is typically a percentage of the employee's salary, up to a certain limit.
For example, an employer might match 50% of an employee's contributions up to 6% of their salary. This matching contribution is essentially free money and a powerful incentive for employees to save for retirement.
Investment Options
Within the 401(k) plan, participants can usually choose from a range of investment options, such as mutual funds, exchange-traded funds (ETFs), stocks, bonds, and money market funds.
The specific investment options available can vary from one plan to another. Employees can allocate their contributions among these investment options based on their risk tolerance and retirement goals.
In the case of a self-directed 401(k) plan, employees can choose what to invest in themselves and fully direct their investments autonomously.
Tax Benefits
401(k) contributions are tax-deferred, which means they are deducted from an employee's taxable income for the year in which they are made. This reduces the employee's current income tax liability.
Taxes are only paid when withdrawals are made in retirement, ideally at a lower tax rate since retirees typically have lower income than during their working years.
Vesting
Employees are always fully vested in their own contributions to a 401(k) plan. However, vesting rules may apply to employer contributions. Vesting determines when employees have full ownership of employer contributions.
There may be a graded vesting schedule, which means employees become gradually more vested in their employer's contributions over time.
Withdrawals
401(k) plans are intended for retirement savings, so there are penalties for withdrawing funds before a certain age (usually 59½).
Early withdrawals are subject to a 10% penalty in addition to income taxes. There are some exceptions, such as financial hardship withdrawals, loans, and early retirement after age 55.
Rollovers
When employees change jobs or retire, they can typically choose to leave their 401(k) funds in their former employer's plan, transfer them to their new employer's plan (if available and permitted), or roll them over into an Individual Retirement Account (IRA) to maintain tax advantages and more control over investment choices.
Required Minimum Distributions (RMDs)
Starting at age 72 (or 70½ for those who reached that age before January 1, 2020), retirees are required to begin taking minimum distributions from their 401(k) accounts to ensure that they start drawing down their retirement savings.
The IRS provides guidelines for calculating the annual RMD amount.
