What is a 401(k) Plan? – Master of Accounting Degrees

A 401 k plan is a retirement savings plan sponsored by an employer. It helps employees to save money for retirement by allowing the money to grow tax free. Here are some important things to know if your employer offers a 401k plan.

A 401k is a Qualified Plan

The 401k plan got its name from the section of the Internal Revenue Service Code that covers qualified retirement savings plans. The term ‘qualified’ means that it meets the IRS criteria for a retirement plan, so it has certain tax benefits.

When you put money into your 401k, you don’t have to pay income taxes on that money when you earn it. You are contributing to your retirement account with pre-tax dollars, meaning that you have not yet paid taxes on those dollars. You will pay the taxes when you withdraw the money in retirement. This is an advantage, since most people are in a lower tax bracket when they retire than they are when they are working.

Your Employer May Contribute Too

Many 401k plans include a provision for a contribution from the employer as well as the employee. This means that if you participate in the plan, your employer may contribute money to your account as well. Most employers will match your contribution up to a certain percentage. They may match all of it or part of it. For example, an employer may match 100% of your contribution up to 2% of your salary. So if you earn $50,000 a year, and you contribute at least 2% of your salary to your 401k, your employer will also contribute 2%, or $1,000. That’s like getting an extra $1,000 to save for retirement.

Your Money Grows Tax-Deferred

When you contribute to your plan, you deposit pre-tax dollars. That means that the amount of your contribution is subtracted from your taxable income when you file your tax return. So if you earn $50,000 per year and you contribute $5,000 to your plan, you will only pay income tax on $45,000. Once the money is in your plan, you can invest it and it will earn money, which is also tax-deferred.

Eventually, of course, the IRS will want you to pay taxes on this money. When you withdraw money from your 401k, you will be taxed on the money you withdraw as ordinary income.

If You Leave Your Job

When you leave an employer with whom you have a 401k, you have several options. You can leave the money in the 401k with your old employer. In some cases, you can move it to a 401k with your new employer, but both employers have to allow this. You could also roll it over into an Individual Retirement Account or IRA, which is also a qualified plan. You can consolidate multiple qualified plans into a single IRA.

When You Retire

Once you retire, you can no longer contribute to your 401k plan, but you can begin taking money out of it without penalty when you reach 59½ years old. When you reach age 70½, you must begin taking money out of your retirement plan, whether you need the money or not. The IRS requires that you take out a certain amount, depending on your age, each year so that they can collect their taxes on it.

A 401 k plan is a great way to save money for retirement. If your employer has a 401k plan, you should seriously consider participating in it, particularly if the employer matches contributions.