The main advantage of 401(k) plans is that they allow retirement savings to grow tax deferred. There are, however, more advantages, especially when compared to individual retirement accounts (IRAs). Find out more about these lesser-known 401(k) benefits – as well as the Roth 401(k). Would you like to be more prepared for retirement? Find out how a financial advisor can help.
401(k) plans may soon be available to a broader range of workers, including part-timer and small business employees. So long as legislation passed almost unanimously in the House, the Setting Every Community up for Retirement Enhancement (SECURE) Act of 2019, also passed in the Senate. Find out the important details about this popular savings vehicle.
401(k): What Is It?
401(k) plans are voluntary savings programs named after the federal tax code section that created them. Both employers and employees can contribute to them. Employees who opt into a 401(k) investment account automatically have a certain amount deducted from their pay. Investors can choose from mutual funds, exchange-traded funds, and target-date funds.
The contributions are pre-tax, which means they are deducted from your income before your taxes are calculated. The number of participants in 401(k)s has increased as pensions have become less common.
The 401(k) Tax Benefit
401k balance provide three types of tax benefits. Contributions are pre-tax, as was just explained. The money isn’t taxed until you withdraw it when you retire. You can withdraw it as early as 59.5 years old.
Additionally, since your contributions are not counted as income, you could be in a lower tax bracket. Therefore, you will have a lower tax bill because you have put money away for retirement.
Third, your savings grow tax-free. Net gains and dividends from a regular investment account are taxable. 401(k) plans allow you to grow your money tax-free while it is in the plan. As a result, your earnings can earn earnings, or as a financial advisor would say, compound. Once you withdraw the funds, you’ll owe taxes.
401(k) Matching Benefits
Employee contributions are often matched by employers, either dollar-for-dollar or 50 cents-for-dollar, up to a pre-determined limit. They do this to encourage people to sign up for the plan, which is voluntary, as noted earlier. Matching your company with talent is also an attractive perk. If your company offers a matching contribution, it is free money that you would not otherwise receive from the company. (The IRS allows companies to set a time period of up to five years before matches are fully vested.) As with employee contributions, the earnings and the earnings’ earnings are tax-deferred.
401(k) Late-Saving Benefits
Unless you started saving for retirement as soon as you started working full time, you aren’t alone. No matter when you decided to quit, you’re in good company. To help all of the late savers (or retirement deniers?) out there, the government allows 401(k) plans for people 50 or older to accept annual catch-up contributions of $6,500. The employee contribution is in addition to the regular limit of $20,500 in 2022 (or $19,500 in 2021). Each year, you can contribute up to $6,000 to your IRA, plus a $1,000 catch-up contribution.