A 401(k) plan is a company retirement savings plan offered by many American employers that has tax advantages built-in for the saver. It is specifically named after a section of the U.S. Internal Revenue Code.
Once an employee signs up for a 401(k), they agree to have a small percentage of each paycheck paid directly into a retirement investment account. The employer may then match part or all of that contribution depending on the employer matching policy. The employee gets to choose among a select number of investment options, usually mutual funds. However, the options are not as diverse as other investment accounts, like IRAs, may provide. The options are also typically much safer and less risk-averse than ones afford by IRAs.
The max amount that an employee or employer is able to contribute to a 401(k) plan is often adjusted to account for inflation. For 2022, the annual limit on employee contributions was $20,500 per year for workers under age 50; however, those aged 50 and over can make a $6,500 catch-up contribution to their account. Total contributions cannot exceed $61,000 per year. If the catch-up contribution is included, the limit extends to $67,500.
In order to begin making withdrawals on all types of 401(k) accounts, one has to be at least 59 ½ years old or meet other specific criteria listed by the IRS, such as disability requirements. If one were to withdraw funds before that allotted age condition, an additional 10% early-distribution penalty tax would be added on top of other taxes one may owe (traditional 401(k)).
Different types of 401(k)s
With a traditional 401(k), employee contributions are deducted from their gross income, meaning the money comes from payroll before income taxes have been deducted. As a result, employee taxable income is reduced by the total amount of contributions for the year and can be reported to the IRS as a tax deduction for that year. Taxes are not due on the money contributed or earned until the employee withdraws the money, usually in retirement. This 401(k) account is very similar to an IRA account in the way its tax savings and advantages work, suited for employees with high reported income.
With a Roth 401(k), contributions are deducted from the employee’s after-tax income. This means that contributions come from the employee’s pay after income taxes have been deducted. As a result, there is no tax deduction in the year of the contribution. When the money is withdrawn during retirement, no additional taxes are taken on the employee’s contribution or the investment earnings. This 401(k) account is also very similar to a Roth IRA with the way its tax savings work and is more suited for those with lower incomes.
A key difference between a Roth 401(k) account and a Traditional 401(k) account is that not all employers offer the option of a Roth account. If the Roth 401(k) account is offered, the employee can have the option of picking either account or a mix of both, up to annual limits on their tax-deductible contributions. Employees are allowed to split their contributions, putting money into both a traditional 401(k) and some into a Roth 401(k); however, their total contribution to the two types of accounts can’t exceed the limit for one account, which in 2022 is $20,500.
What are the major objectives of the 401(k)?
401(k) accounts are simple and great investment accounts to help achieve your retirement goals. For most people, the desired goal of their investment is to be earning growth over time and to provide their family with an additional income stream during retirement while also minimizing the impact on their taxes. To determine your retirement goals, you can make a list of general, specific, and investment goals you expect to achieve before retirement. This will help you and your partner stay on track.
Why is the 401(k) so important?
The latest health reports and data shows that life expectancy is increasing, leaving a greater number of years in retirement as well as increasing health care costs. Coupled with the future of the financial and economic market, these increasing costs may hinder one’s ability to retire without the proper amount needed or the retirement plan itself. In order to plan for longevity in retirement, one needs to actively participate in financial planning, specifically retirement plans, and one needs to accumulate more money than they actually think they need. Many retirement experts project that one needs roughly 80 to 90 percent of their pre-retirement yearly income to sustain their retirement lifestyle each year. For many, this can roughly equate anywhere from $1 to $2 million, which can be difficult to achieve without the right retirement account or investment strategy. A 401(k) account is an optimal investment account that can help you reach your retirement goals. Not only does this account have tax advantages, but it also has employer matching policies which differentiates this plan from other investment plans like IRAs.
What are the advantages of 401(k)?
A 401(k) plan lets you reduce your tax burden while saving for retirement. Not only are the earnings tax-free, but it’s also hassle-free since contributions are automatically subtracted from your paycheck. This process becomes hassle-free as investing a certain percentage of your savings each month or year will be automatically done for you. In addition, many employers will match part of their employee’s 401(k) contributions, effectively giving them a free boost to their retirement savings. This essentially adds a secondary free contribution from your employer, something that other investment accounts, like IRAs, for example, do not provide.
Why you should consider 401(k)
One should consider a 401(k) for the many premium advantages it has to offer as an investment account. Contributions to a traditional 401(k) are taken directly out of your gross income before federal income taxes are withheld. Due to the fact that your contributions are pre-tax, it may lower your total taxable income, meaning you owe fewer taxes to the government. It may even put you in a lower tax bracket! Your contributions are then tax-deferred until you withdraw them in retirement. Most individuals end up being in a lower tax bracket once they retire as they stop working. On top of that, contributions are taken automatically from your gross income, making the process simple and effortless.
How Arrowroot Family Office can help you with 401(k)?
If a 401(k) account sounds like the right investment account for you, Arrowroot Family Office can help you begin your investment journey. Arrowroot Family Office understands that creating a comprehensive retirement plan is a challenge for many people. As a result, Arrowroot Family Office specializes in helping individuals achieve financial independence so they can enjoy their retirement and fulfill their retirement goals. Arrowroot Family Office uses different retirement plans tailored to different needs and goals depending on each financial situation. Thus, Arrowroot Family Office can help individuals become confident in their retirement and prepare for any unforeseen events.
Helping you achieve your evolving financial objectives
Frequently asked questions
What is a 401(k), and how does it work?
A 401(k) is a retirement savings and investing plan that most employers offer. This retirement plan gives employees a tax break on money they contribute. Contributions are automatically withdrawn from employee paychecks and invested in funds of the employee’s choosing. Employees are given a list of available offerings to invest in.
Are a 401(k) and IRA the same thing?
They are not the same. A 401(k) is a type of employer retirement account, while an IRA is an individual retirement account. 401(k)s can provide employer matching benefits, while IRAs are known for their pre-tax and tax-deferment benefits. Both investment accounts also have different contribution limits.
Is a 401(k) a good investment?
401(k)s can be a fantastic investment opportunity to save on your yearly taxes. This option is especially great for employers who have a great employer matching policy that can earn employees greater potential earnings.
How much does a 401(k) earn per year?
Typically, 401(k)s see average annual returns of 5 to 8%, compared to the average annual returns of an IRA, which sees 7% to 10%. However, this number may be higher or lower depending on your investment strategy.
Is a 401(k) better than a savings account?
Savings accounts are ideal for short to medium saving goals, perfect for emergency funds or short savings goals. However, savings accounts return low yields. 401(k)s, on the other hand, are better for longer saving goals that are intended for use during retirement.
Is 401(k) safer than IRA?
401(k) is considered to be not as secure as an IRA due to the event of company bankruptcy or an adverse lawsuit. However, a spouse may still be able to receive those funds after those events.
Is it better to invest in an IRA or 401(k)?
If possible, it is important to maximize both your IRA and your 401(k). Depending on how high your employer matching policy is, it would make sense to maximize one over the other. If your employer does not have an employer matching policy, then it would be best to just strictly invest with an IRA account to enjoy all of the tax benefits.
Are 401(k) contributions tax-deductible?
Your 401(k) contributions can reduce your tax liability at the end of the year as well as your tax withholding each pay period; however, you don’t actually take a tax deduction on your income tax return for your 401(k) contributions.
Can 401(k) be used for college?
You can use your 401(k) account for education expenses; however, that should not be your primary option. 401(k) plans are specifically dedicated to retirement savings. If you were to withdraw funds before the age of 59 ½, you would incur a 10% premature distribution penalty on the withdrawal. Thus you would lose a substantial amount of money compared to other investment accounts like IRAs, so use this option as a last resort.
Can 401(k) be rolled into an IRA?
Yes, you can roll a 401(k) into an IRA if the 401(k) provider will allow it. The easiest way to roll a 401(k) into an IRA is to request a direct transfer, which moves the money from your 401(k) into your IRA. People often roll over their 401(k) savings into an IRA when they change jobs or retire; however, the majority of 401(k) plans may still allow employees to roll over funds while they are still working. A 401(k) rollover into an IRA often offers the opportunity for more control, more diversified investments, and flexible beneficiary options.
What happens if I over-contribute to the 401(k)?
If one were to go over their 401k contribution limit, they would have to pay a 10% penalty for early withdrawal, as one must remove the funds. The funds will be counted as income, and those extra contributions will be double-taxed for each year the extra funds stay in the retirement account.