What is a 401(k) Plan?
A 401(k) plan is one of the most popular retirement plan benefits available today. Nearly 50% of all companies in the U.S. offer 401(k) plans to their employees. Nearly 40 million Americans entrust a big part of their future to their 401(k) plans.
Why is it so popular? A 401(k) plan lets you reduce your taxable income and save money for retirement on a tax-deferred basis.
Many employers match employee contributions at a rate of 10, 25, 50, and sometimes even 100 percent, which makes savings through a 401(k) plan pay off even before it begins to acquire investment earnings.
How does a 401(k) plan work?
First, you select an amount to be deducted from your paycheck each pay period. Currently, plan participants can contribute up to a set limit. The limit is $16,500 for 2011. Your company has established rules on when you become eligible and how much of your compensation you can contribute. See your plan sponsor for the provisions of your plan.
Next, you select from the investment options your plan provides. These options vary from plan to plan. Generally, several options are offered, ranging from conservative to aggressive.
You will receive periodic reports at least annually, but often more frequently. These reports show the contributions made to the plan, gains/losses, ending account balance, and your vested amount. These reports also show the pie chart with your investment elections.
You can make changes to the amount you are contributing as well as your investment selection based on the provisions provided by your plan. Check your summary plan description for details.
Finally, sit back and watch how your retirement account grows!
What are the tax advantages of a 401(k) plan?
There are three tax advantages to saving in a 401(k) plan:
Contributions are made pre-tax - You pay yourself first, even before you pay Uncle Sam. Your 401(k) contributions are deducted from your paycheck before federal income taxes are withheld. In some states, you don't pay state income tax on your contributions or earnings until withdrawn either.
Contributions grow tax deferred - You don't pay federal income tax on your contributions or the earnings until you withdraw it at retirement. In some states, you don't pay state income tax on your contributions or earnings until withdrawn either.
Taxes paid at retirement may be less - Most likely you'll be in a lower tax bracket when you retire.
You may find that, by changing from your current savings program to a 401(k) plan, you can enjoy a sizable increase in your take-home pay.
By deferring taxes your retirement funds grow much faster than normal investments. Without withholding money for taxes, interest compounds on every penny of your investment. Assuming you earn the same rate of interest, your money grows more quickly in a 401(k) plan than in non-qualified plans you set up on your own. Because your contributions are made before taxes, you can contribute to your 401(k) plan and not see a big difference in your take-home pay.
What are other advantages to saving in a 401(k) plan?
Employer match - If your company provides a match on your contributions, it is the same as earning an additional 25, 50, or even 100% return on your contributions each year you participate.
Choose your own investment - As a retirement plan investor, you have the opportunity to design and manage an investment portfolio that will allow you to meet your financial goals for retirement.
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