Financial security in retirement is not a certainty. To ensure that your future is secure, you must take the necessary steps to build wealth while you are young. A 401(k) is a type of retirement savings plan sponsored by employers. With a 401k, employees are encouraged to save a portion of their pre-tax paycheck. However, there are certain 401(k) contribution limits that differ among individuals.
Accumulated contributions are not taxed until the funds are taken from the account once you have reached retirement age. 401(k) contributions are popular plans as the money is withdrawn automatically from your paycheck and invested into your account.
How Do 401(k) Contributions Work?
The term ‘401k’ comes directly from the section of the tax code, specifically subsection 401k, which established the retirement arrangement. Through a 401k, employees contribute money to an individual account by signing up for automatic deductions from their regular paychecks. There are several types of 401(k) plans, and depending on which is chosen, the tax break arrives when you contribute the funds or when you withdraw them at retirement. However, know that not all employers offer 401(k) plans. However, you can still reap many of the same tax benefits from an individual retirement account.
Employer-sponsored retirement plans are typically grouped into two main categories: defined benefit (DB) and defined contribution (DC). With a defined benefit plan, the employer promises to pay out a defined amount to any retiree who meets strict eligibility criteria. Generally, a DB plan pays retirees a lifetime monthly benefit if they meet certain age and service requirements. DB was the most common form of employer-sponsored retirement program 50 years ago. With DC plans, the plan defines any contributions that employers can make. It does not define the benefit that will be received at retirement.
What are the Benefits of 401(k)’s?
Among the various types of retirement accounts available, 401(k)’s remain one of the most well-known and popular among employees. Many employers offer to match employee contributions, meaning ‘free’ money for your account based on how much you contribute. Some employers match your contribution dollar-for-dollar, while others offer 50-cents-on-the-dollar. An employer may also choose to match a certain percentage, such as 6 percent of your contribution amount. This can result in substantial savings.
Another major advantage of 401(k)’s comes in the form of bigger savings through less initial tax debt. Contributions to a traditional 401(k) plan are withdrawn from your paycheck before taxes can be taken, which allows you to make contributions without feeling as much of a deduction. For example, say the IRS usually takes 20 cents of every dollar you earn for taxes. This means that saving $800 per month without a 401(k) requires you to earn $1,000 as $200 is given to the IRS. With a 401k, contributions are made before taxes.
Over time, any investments made through contributions will grow in your account. As a major perk, the funds in your 401(k) will grow unimpeded. In the case of both traditional and Roth 401(k)’s, as long as the money you contributed remains in your account, you will pay no taxes on your investment’s growth. No taxes are paid on interest, on dividends, or on investment gains. However, this does not mean that your contributions and investment growth are free from taxes forever. When you begin making withdrawals at retirement, you will owe income taxes to the IRS.
In addition to traditional 401(k)’s, Roth 401(k)’s are a popular alternative that can provide a number of benefits. Unlike traditional 401Ks which require the removal of taxes at retirement, Roth 401(k)’s have taxes taken out right away. After the taxes are removed at the time of the contributions, the money is put in an account where it is protected once again with the same tax shield. However, when you begin taking distributions at retirement, you owe nothing to the IRS. As you have already paid your due while working, any money in your account when you retire are post-tax dollars.
You may be concerned about what will happen to your 401(k) if you choose to leave your job. You will be happy to know that you can take it with you. If you decide to leave or switch jobs, your 401(k) account can roll over into a new account at your new job. You may also want to consider converting your 401(k) into an IRA. An individual retirement account (IRA) allows individuals to save for retirement on a tax-deferred basis or with tax-free growth. IRAs are often used by employees who do not have access to 401(k)’s.
What Are the 401(k) Contribution Limits?
The maximum amount that employees can contribute to a 401(k) for 2018 is $18,500 if they are younger than 50 years old. Employers who are age 50 or older have higher 401(k) contribution limits, being able to contribute an additional $6,000 per year in the form of “catch-up” contributions which brings their total contributions for 2018 to $24,500. If you contribute more than the allowed amount in a given year, you could face stiff IRS penalties, as well as double taxation on your contributions. If you have contributed too much to a 401k, it is best to correct the mistake by having the plan administer you a refund for the amount exceeding the 401(k) contribution limits.
Contact a Financial Consultant Today
Investing in a 401(k) plan is one of the best ways for employees to prepare for retirement. If you currently have a 401(k) plan in place or are considering opening a retirement account, you may be wondering what the best strategy is to ensure maximum savings for your future retirement. The experience and knowledge of financial consultants can help you make well-informed decisions about your investments. For more information about 401(k) contribution limits or for assistance with growing your portfolio, contact the financial consultants at IFG.