What are 401(k) Accounts?

What are 401(k) Accounts? image

401(k) plans allow employees to plan and save for retirement. After years of new IRS rulings and other governmental changes they are considered by many to be among the best options for this purpose. Considered a better option than pension plans, many employers now offer 401(k) (or a similar plan) for employees.

The benefit of a 401(k) plan extends beyond deferring taxes. They reduce your taxable income, account funds can gain interest, plans are portable (if a participant leaves their current employer the 401(k) remains accessible and may be transitioned into a future employer's plan) and many employers contribute to employees’ 401(k)s. Unlike pension plans, if something happens to a participant’s employer (i.e. bankruptcy or closure) their funds are protected entirely from losses as a result of that event.

Although some groups cannot offer 401(k) plans, many of them are able to offer similar options. For instance state and government employees offer a 457 plan, while public hospitals, educational organizations, churches and non-profit organizations have 403(b) plans. Speak with your employer about the specific terms and differences of your plan, if any.

Types of 401(k)

 

There are several types of 401(k) plans an employer may choose from.

  • Traditional 401(k) – Contributions are pre-tax (must pay tax at time of eligible withdrawal). Employers may contribute to the plan on the employee’s behalf, match contributions or both. There is annual nondiscrimination testing to ensure highly compensated employees are not being favored.
  • Safe Harbor 401(k) – Similar to the Traditional plan, although employers must contribute to all fully vested employees’ plans. Does not have as many rules binding it – such as no requirement for annual nondiscrimination testing.SIMPLE 401(k) – Designed for small businesses. It is similar to a Safe Harbor plan, but only available to businesses with fewer than 100 employees. Employees may not receive any other employer contributions with a SIMPLE 401(k) plan – such as cafeteria plan contributions.
  • Roth 401(k) – The Roth 401(k) combines some of the best aspects of both a 401(k) plan and a Roth IRA. Under the Roth 401(k), employees can decide to contribute funds on a post-tax basis, in addition to, or instead of, pre-tax contributions under a traditional 401(k) plan. The difference between a Roth 401(k) and a traditional 401(k) is that the Roth version is funded with after-tax dollars while a traditional 401(k) is funded with pre-tax dollars.

401(k) Plan Restrictions

 

All of the plan types have specific rules that govern how they may and may not be used. Every account has an early withdrawal penalty (10% of the amount withdrawn) if funds are removed before the age of 59 1⁄2, unless it qualifies as one the few exceptions to that penalty. They also allow for loans, which are considered non-taxable income, but must be repaid with after-tax dollars. After turning 70 1⁄2 years old account holders must begin withdrawing funds or face a severe penalty of 50 percent the amount that should have been withdrawn (unless you are still working at the time).

Tax Savings with a 401(k)

Did you know that your 401(k) account is generally referred to as a tax deferred savings? That’s because you do not pay any tax on the contributions made into the 401(k) during the year. Also, the gain, interest and dividends are also tax deferred until the money is withdrawn.

401(k) contributions are taken from your paycheck before taxes are deducted. By funding your 401(k), you lower taxable income. The amount of the reduced taxes will vary with the amount you contribute and your tax bracket. As an example, if 20 percent of your income is withheld and you invest $100 into your 401(k), the net difference in your actual take-home pay may be less than $100.

The Savers Credit, formally known as the Retirement Savings Contributions Credit, applies to individuals with the following filing status and income levels.

 

  • Single, married filing separately, or qualifying widow(er), with income up to $27,750
  • Head of Household, with income up to $41,625
  • Married Filing Jointly, with income up to $55,500

Did you know that if you are eligible for this credit and you make contributions to a 401(k) plan, you may be able to take a credit of up to $1,000 or up to $2,000 if filing jointly? The credit is a percentage of the qualifying contribution amount, with the highest rate for taxpayers with the least income.

401(k) plans can help you save for both now and in the future. For more information, speak with a financial specialist.

 

This article is intended to provide accurate and authoritative information on the subject matter covered. It is distributed with the understanding that FBMC is not rendering professional or medical advice and assumes no liability in connection with its use.

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