The 401(K) is becoming more and more popular among employees. Generally, you will be offered a 401(K) plan by your employer when you are qualified. So, what is a 401(K) and how does it work?
What is a 401(K)？
A 401(k) plan is a tax-qualified, defined-contribution retirement account, which is named after a subsection of the U.S. Internal Revenue Code. Employers can choose to offer 401(K) plan to employees or not. Workers can make contributions to their 401(k) accounts through automatic payroll withholding, and their employers can match some or all of those contributions. There are two kinds of 401(K), the traditional 401(K) and Roth 401(K).
The investment earnings in a traditional 401(k) plan are not taxed until the employee withdraws that money, typically after retirement.
Who can have a 401(K) account?
Basically, anyone who has a job can be offered the opportunity to open a 401(K) account by his/her employer. It’s becoming more and more popular. There’s no cutoff age. There should be no discrimination. The maximum age and service conditions permitted by law are age 21 and 1 year of service. In that case, employers cannot deny anyone the right to participate in a 401(k) plan as long as employees are working. However, not every company would offer a 401(K) plan to employees.
How does the 401(K) work?
Known as a defined-contribution plan, the 401(K) allows both employee and employer make contributions to the account, until the amount reaches the limits set by the IRS. This contribution will directly go to your traditional 401(K) account without tax. Some employers match your contributions up to a certain amount. For instance, if your employer matches 50%, that means you invest 1 dollar, the employer will invest 50 cents to your account.
Employees are also responsible for choosing the portfolio within their 401(K) accounts, including bonds, mutual funds and more. For the investment income, you don’t have to pay for the capital gain tax or dividend tax. When withdrawal, all your gains will be treated as “ordinary income”.
The maximum amount that one can contribute to a 401(K) plan is adjustable. As for 2019, the basic limits on employee contributions are $19,000 per year for workers under age 50 and $25,000 for those 50 and up.
When you change job, the 401(K) account can be moved to your new employer or just roll over to an IRA account.
When can withdrawal money from your 401(K) account?
You are supposed to withdraw the money after the age of 59.5, otherwise there will be a 10% tax penalty, since the 401(K) is set for retirement. After the age of 70.5, you must withdraw a specific percentage of money from your account.
Comparison between a traditional 401(K) and Roth 401(K).
Some employees may be offered with two plans: traditional 401(k) or a Roth 401(k). What’s the difference between them?
For traditional 401(k), the money you contribute to is deducted from your pretax income, however, you must pay tax when you withdraw according to the tax bracket at that time. For Roth 401(K), the contributions are made after taxes so there will be no tax when you withdraw the money.
Young people may choose Roth 401(K) because they think they may be in a higher tax bracket when they retire. However, nobody can predict the future, so it is up to you to decide which 401(K) account you are going to have.