What is a 401k? - Full Explanation

What is a 401k? - Full Explanation

When it comes to retirement accounts, most are likely familiar with what a 401k is and what it entails. Most often (although there are different types of 401ks/) this is an account that many employers will offer. What then happens is that money is taken from the employee's paycheck and deposited into this 401k retirement account. The money gets invested in a variety of different funds—often the employee will choose the funds into which it is deposited. There is a tax break associated with a 401k, although it differs depending on what type of 401k you are signed up for. Some will enjoy a tax break when they contribute the money; there are also 401k plans that allow you a tax break upon withdrawing that money when you retire. In this article, we look closer at 401ks in terms of how they work and the benefits associated with being enrolled in a 401k plan.

Starting a 401(k/)

While not all employers will offer their employees a 401k option, many now do. If yours does not happen to offer a 401k plan, you can look into investing in an IRA. They also have numerous benefits as far as both savings for retirement and the tax breaks you would be eligible to receive. Keep in mind, an IRA does tend to have lower contribution limits than a 401k does. And if your earnings are on the higher side, there may be some further limitations with an IRA.

When an employer offers a 401k, they also usually offer a matching option; that is to say, the employer agrees to match what you put into the 401k. Some will agree to match your contributions dollar for a dollar while others might say that you can receive up to .50 on the dollar for your 401k contributions. If your employer does offer a 401k matching program, it is highly advisable to take advantage of this offer as this will allow you to save even more (and more quickly/) for retirement.

There are also the benefits of having pretax contributions. This simply means that the contributions are taken out of your paycheck before that check is taxed. So for example, if your paycheck is for $1000 and you contribute $200 to your IRA, then you are only taxed on $800 for that particular paycheck. This can dramatically increase the amount of money you save and the value of your dollar in the long run.

Also, another bonus, 401k contributions can lower your income taxes for the year. The amount you invest into that 401k gets deducted from your yearly income. If for instance, you make 70k in a given year. And you consequently invest 25,000 into your 401k. That means that on your tax returns, you are only going to be taxed on 45k as far as your income goes. You are thus shielding 25k worth of your income by putting that money into your 401k plan.

This however is not the case forever; in other words, you are eventually going to have to pay tax on that money that you invest in your 401k. The money that you put into your retirement account is tax-deferred. When you do go to withdraw your money, this is when the IRS will end up getting their cut. So, you want to keep this in mind and remember that when it comes time to use the money from your 401k upon retirement you will at that point have to pay taxes on it.

The benefits of the Roth 401k could potentially come into play here. Taxation works a bit differently with the Roth account. You still do get to have a tax shield in this instance. However, the major difference with a Roth 401k is that when you do pull the money out upon retiring, you are not taxed. With a regular 401k when you do take the qualified withdrawals you get taxed on the money you take out. This is a key difference. So how come it is that you do not get taxed upon withdrawing funds as far as a Roth 401k goes?

With the regular 401k, you are investing pre-tax dollars and so the government at that point hasn't gotten their cut. When you do a Roth 401k you are investing post-tax dollars so this means that you've already paid your taxes on that money. The IRS cannot tax you twice on your income. If you paid initially, they cannot go back and tax you on the same amount when you withdraw funds from your retirement account. You have to carefully weigh what would be most beneficial to you given your financial situation: getting to save on income tax now with a regular IRA or not having to pay on retirement funds down the road when you retire.

Another question that many people have regarding a 401k plan is whether or not they will be able to take this plan with them when and if they go to another job. After all, the account was set up by your current employer, so it must belong to them, right? Wrong. You absolutely can take your 401k retirement account with you to a new job. And you most definitely should as you have built up savings in that account over the time you were at that job. What most do upon getting a new position at a different company is to roll over the money in their current 401k over to a new fund. At this point, you might consider rolling the savings you've accrued into an IRA account.

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