I am working this week in revising retirement plans contributions for some of my clients participating in 401K plans. I am sharing with you this week the basics and the tax advantages of this retirement plan.
How Does a 401k Work? – The Basics
- As a 401k participant, you tell your employer how much of your paycheck you want to deposit into your account. Usually, you can deposit as much as 15 percent of your pay into your account each month; however, employers can make the limits lower if they choose. The IRS does place limits on how much you can contribute on an annual basis. For 2015, the contribution limit is $18,000.
- Your contributions are taken out of your paycheck on a pre-tax basis. You never even see the amount you contribute to your account, which makes it easier to part with it.
- Most employers match some of your contributions with money of their own. No matter how much your employer matches, though, you will want to take advantage of this “free” money. In fact, the minimum amount you should contribute is exactly what your employer matches. So, if your employer will match up to six percent, then you should contribute at least six percent. Otherwise, you are leaving money on the table.
- 401k plans are managed by a third-party administrator who invests the contributions in money market accounts, bonds, stocks and other funds.
Tax Benefits of a 401k Plan
- Free money. This is probably the number one reason why employees like 401k plans. As mentioned above, participants’ contributions are typically matched by their employer up to a specific percentage. This matched amount really is free money. It isn’t part of your wages and you don’t really have to do anything for it except save for retirement, which is a good idea anyway.
- Lower taxable income. Because your contributions are made on a pre-tax basis, your take-home pay is actually higher than it would be otherwise. This is due to the fact that the actual income amount on which you are taxed is lower; therefore, the taxes are lower as well. You will have to pay taxes on this money when it is distributed, but that’s many years down the line.
- You can have a bad memory and still save money for retirement. You contributions are deducted from your paycheck with you doing anything except declaring the amount you want taken out. There’s nothing for you to think about once you’ve made your contribution election. Meanwhile, your account will continue to grow.
- You can access your 401k funds in an emergency if necessary. Loans amounting to as much as 50 percent of your vested balance can be distributed if you find yourself in a financial pinch. You will have to repay your loan to yourself with interest, and the amount you have out on your loan will not invested while it is outstanding, but if you can’t get a loan any other way, this is a viable option.
- You don’t have to know much about investing to have a successful 401k. Your money is managed by a professional administrator who knows how to invest your funds appropriately. You do want to keep an eye on your portfolio, but you don’t have to watch your account on a daily basis.
As employee the nicest thing about this kind of investment is that your employer pretty much takes care of everything for you. All you have to do is decide how much you want to contribute and where you want to put your money and you’re done.
If you need more information about this plan, please call me.
I wish you to have a Happy Thanksgiving with your family.
Julio Jiron, CPA