Preparing for retirement is crucial, and selecting the right 401(k) plan is pivotal in ensuring a comfortable and secure future. But how will you settle your bills and maintain a good life when you retire? Understanding the importance of saving for retirement is essential, and one of the optimal ways to do so is by utilizing a retirement savings account, such as a 401(k).
If your company offers a 401k plan to its employees, then it’s an added advantage for you. Participating in this plan allows you to engage in investments that can significantly boost your retirement savings, with the potential for employer contributions enhancing its appeal.
What is a 401(k) Plan
A 401(k) plan is a defined contribution retirement plan employers offer to employees. In this retirement plan, employees receive tax breaks on their contributions into a long-term investment. The government does not tax the earnings made from these investments until the money is withdrawn.
In a defined contribution plan, the contributions made to this savings account and the effect of its investments determine the account’s available balance. An employee must make contributions to this account, but an employer doesn’t need to make contributions.
If an employer wants to contribute to an employee’s account, the employer might choose a portion of the contribution, not the total amount.
How does a 401(k) Work
In the 401(k) plan, you will sign up for an account and decide how much you will contribute to this retirement account. As you receive your paycheck, that amount(contribution) will be withdrawn and paid into your retirement account.
Although you can decide on the amount to contribute, you and your employer still have contribution limits. This limit is usually between 3% and 6% of your gross salary.
Your employer can also contribute a portion to your contributions, but they are not obliged to.
Types of a 401(k) Plan
There are two types of 401(k) plans; Traditional and Roth 401(k). Let’s explore each of them so that you can make an educated decision when choosing any.
Traditional 401(k) Plan
In this 401(k) plan type, your contribution is deducted and allocated to your retirement savings account before income tax is calculated. That is to say, the contributions you make into this account helps to reduce your income tax.
Here, you get to make investments from the contribution, and earnings gained from these investments are tax-deferred.
In this 401(k) plan type, you will only make tax payments on investments and contributions when the money is withdrawn.
When your employer matches a portion of your contribution, income taxes will be deferred until the money is withdrawn from the savings. Do you want a simulation of how much you could get at retirement? Check our 401k Calculator to get a breakdown of your retirement savings at the end of your retirement age.
Roth 401(k) Plan
An employer can make contributions in the Roth plan after income tax is deducted. This means that this type of 401(k) plan does not reduce your income tax.
As an employee, if you pay lower income tax currently, a Roth 401(k) plan might be a good option for you.
With Roth 401(k), you won’t pay any tax when accessing the funds in your retirement account.
Features of a 401(k) Plan
You could gain so much from this plan as an employee, and it could keep you on the right side of achieving your retirement goal. The features this plan offers include:
Treatment of taxes
For the traditional 401(k) plan, the employee’s income taxes are reduced due to the amount deposited into the plan. Tax is only charged on any amount that is withdrawn.
Treatment of taxes for the Roth type of the 401(k) plan differs slightly. Taxes are deducted when money is deposited into a Roth 401(k), but the money is tax-free when withdrawn.
In a 401(k), contributions are subject to limits guided by the IRS, impacting the amounts allocated to your retirement account. For the 2020-2021 financial year, the annual contribution limit for an employee below 50years was $19,500. For those who are 50years and above, the maximum contribution limit was $26,000.
If employers match their employee’s contributions, the limit for those below 50 years is $57,000 and $63,000 for those above 50 years.
Required Minimum Distribution
Distributions most times are referred to as withdrawals from a 401(k) plan. The IRS requires that if retired owners reach the age of 72 and above, they must withdraw a portion of the money in their account. But they will not have to withdraw their money if they are still working at that age.
If you own a 401(k) account, you can make withdrawals from your account only when you’re up to 59.5 years. Also, you can make withdrawals if you meet up with any guidelines given by the IRS.
You will be charged a penalty tax of 10% if withdrawals are made for any purpose except for retirement. If you want to withdraw to deal with a sudden emergency, you won’t be charged a penalty.
This emergency may include but is not only restricted to burial expenses, buying a residence, or paying for medical bills that are not insured.
Benefits of a 401(k) Plan
As an employee engaged in this retirement plan, you have three significant benefits you stand to gain from a 401(k) plan.
1. Tax Breaks
The 401(k) plan offers various tax advantages related to retirement savings. The first is that, you can make contributions before tax from your gross salary. As a result, you will not pay taxes on the retirement savings except when you access the contributions.
Secondly, your contributions under the 401(k) retirement plan will not be counted as income.
Thirdly, due to not paying tax on your retirement contribution, your savings gets to grow tax-free as long as it remains in the 401(k) plan.
2. You Have the Benefit of Employer Match
In this plan, you have the opportunity to receive an employer match which could be a portion of your contribution. Employers will often choose the percentage of your contribution to match up.
3. Your 401(k) Plan is Protected From Creditors:
If your finances don’t seem to be on the positive side at a time, you won’t have to worry about your creditors taking over your savings. Your 401(k) plan won’t be affected because it’s protected by ERISA (Employee Retirement Income Security Act).
Drawbacks of a 401(k) Retirement Plan
As much as this plan has benefits attached to it, it has some downsides you need to look into, such as:
1. Limited Investment Options
Suppose you subscribe to a 401(k) retirement plan. In that case, your investment options will be restricted to a selection of mutual funds and Exchange Traded Funds (ETFs). So, you cannot invest in a security or asset that is not supported by this plan.
2. The 401(k) Involves a Lot of Fees.
One major setback you might experience in using the 401(k) as a retirement savings account is that there are various fees associated with this plan. For a detailed understanding of these fees, you can refer to the Employee’s Guide to Retirement Plan Fees by the U.S. Department of Labor.
Working for a big company might make it easy to spread these fees among other employees participating in this plan. As an employee, you will have to pay administrative fees, individual service fees, investment fees, and custodial fees. If you pay high fees in your 401(k), you should invest a lot more so you can get your employer match.
3. Limitations in withdrawal scheme
The 401(k) accounts have a specific age for withdrawal referred to as the required minimum distribution, which begins at age 72. When you get to this age, you might be forced to withdraw your savings, and you’ll be entitled to receive social security benefits. One thing is that your social security benefit will be taxable.
4. You Can withdraw Only When You Retire.
The 401(k) savings are strictly for retirement. That’s why you can’t withdraw them for any other purpose other than retirement. If all your investments are in your 401(k) account and at the age of 55 you decide to quit your job, you might not be able to depend on your investment to sustain you.
It is clear that the 401(k) plan has a lot of benefits you stand to gain if you utilize this as your principal retirement savings account. As an employee, you should compare and contrast the benefits with the disadvantages so you will be able to know which one is suitable for you.