How does a 401(k) work?

A 401(k) plan is a retirement savings plan that is funded by employee contributions and often matching contributions from the employer.

There are many advantages to 401(k) plans. You get an immediate tax break since the employee is allowed to contribute to their 401(k) with pre-tax money, it reduces the amount of tax paid out of each pay check.

For example if an employee earns $50,000 in a year and deposits $3000 into their 401k account during that year, they are only taxed on the remaining $47,000. All employer contributions and any growth in the capital grow tax-free until withdrawal. The compounding effect of consistent periodic contributions over the period of 20 or 30 years is quite dramatic.

You have the possibility of a matching contribution from your employer - most commonly 50 cents on the dollar for the first 6 percent you save. If your company matches your contributions, it's like getting extra money on top of your salary. As an employee you can decide where to direct future contributions or current savings, giving you control over your investments. Your contributions can also be moved between plans if you change jobs. There are some non-discrimination tests a 401(k) must meet. Such as rules affecting higher earners. If you earn more than $105,000 a year it may not be permissible to contribute as high a percentage of your earnings as someone earning less.

The 401(k) is a similar retirement plan to an IRA, however an IRA won't allow you matching company contributions, and personal IRA contributions are subject to much lower limits. Your 401(k) is protected by pension laws in the event of attachment by creditors or an attempt for it to be assigned to someone else, with exception to domestic relation court cases.

For all the benefits of a 401(k) retirement plan there are certainly a few other things to consider. If you were to withdraw the money from your account, you will owe income taxes on the amount withdrawn plus an additional 10% penalty. While there are guidelines in place for what’s permissible in your plan, your employer may set tighter restrictions. The limit on contributions is $15,500, and you may add another $5000 if you are over 50yrs old. There may be a certain time period that you are required to be at your company, in order to retain 100% of your employer matches. Any money you have contributed remains yours.

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