How Do 401(k) Retirement Plans Work
A 401(k) is a tax-deferred savings plan. It also provides a way to lower the amount of taxable income. In 1978, the Internal Revenue Code was amended to authorize the use of these tax-deferred programs to assist employees of most private businesses to save for retirement. The plan gets its name from its place within the Internal Revenue Code Ð section 401, paragraph (k).
Once enrolled in a 401(k), you are part of a defined contribution plan. This means that the contribution, or the amount you put in to the fund, is defined either by you, the employee, or your employer, depending on the regulations on the plan at your place of work.
In most cases, the employee decides how much to contribute to their 401(k). Employers typically set a limit, and if they choose not to set limits immediately, they maintain the right to do so whenever necessary. The IRS limits 401(k) deposits per year to $15,000.
Once your deposit is made, it travels to the hands of a third party administrator for investment. Where your funds are invested and in what quantity are entirely your decisions. However, these decisions help determine how much your money will grow.
Some employers will match the amount you deposit each month as an incentive to enroll and stick with the company's 401(k) program. This is essentially free money every pay period that your employer is contributing to your happy retirement. So, although depositing a generous amount into a fund for later may seem less than appealing, it's smart to contribute as much as you can afford.
You also have the opportunity as a 401(k) participant to see a reduction on your taxes immediately. The amount allotted for 401(k) is taken out before taxes, and taxes are never incurred as long as your contributed funds remain in the account. If you decide to withdraw any of the funds before 60 years of age, you both pay taxes and incur a 10% penalty from the IRS.
Overall, a 401(k) is a great choice for putting away money for your future. As with all things, it's important to read the fine print and to research your investment options. Be aware of the fees charged by the plan itself when choosing a 401(k) plan. Most importantly, start early and invest generously to reap all the possible benefits when you're ready to cash in on your investments later down the road.
