What is a 401(k) Plan?

piggy bank 401k plans

A 401(k) is an employer-sponsored retirement plan. Its name comes from Section 401(k) in the Revenue Act of 1978. This allows employers to offer tax-advantaged savings accounts to employees. Employees can set up contributions from their paycheck, and most employers offer contribution matching up to a certain amount.

As money piles up in a 401(k), you can start putting it to work for you. The 401(k) plan providers offer different investment options. And the sooner you start investing, the more money you’ll have in the future. So, let’s look at some common 401(k) questions…

401(k) Employee Contribution Limits for 2019

If you have an IRA, you’re probably familiar with contribution limits. The IRS determines a maximum amount an individual can contribute to their 401(k) plan(s) each year. For 2019, the maximum contributions are as followed:

Total employee contribution (under 50 years of age)—$19,000
Total employee contribution (over 50 years of age)—$25,000

This includes a “catch-up” contribution of $6,000

401(k) Employer Contribution Limits and Rules

If your employer offers contribution matching, they also have a contribution limit. It’s the lesser of:

100% of employee compensation, or
Employee under 50 years of age—$56,000

Employee over 50 years of age—$62,000

On top of that, employers that offer matching have different rules. And 401(k)s are contribution-defined plans. This means the amount your employer will contribute is pre-defined. You can find details in your plan’s summary description.

Employers use a formula to determine how much to contribute. For example, one company might offer a half match up to 6% of your salary. So if you make $100,000 and contribute $4,000 (4%), the company chips in $2,000. That’s half of your 4% contribution. Or if you contribute $6,000 (6%), the company puts in $3,000. This would max out the company’s match for the year. If your employer offers a full match, they would contribute $6,000 as their max. Although, you can still contribute more up to the total employee contribution limit. You can always consult your plan summary or HR department with any questions you have about your employer’s contributions.

A company’s 401(k) contribution match is free money. So it’s good to take full advantage. Whenever possible, try to max out your employee’s match. The money you put in is also tax advantaged. Let’s look at that next…

401(k) Taxes—Traditional vs. Roth

Many employers offer both traditional and Roth 401(k) plans. And sometimes you can contribute to both (without exceeding the limits listed above). However, employer contributions can only go towards a traditional 401(k).

There are distinct tax differences between traditional and Roth 401(k)s. A traditional 401(k) has pre-tax contributions. These are taken out of your paycheck before taxes are deducted. This benefit reduces your taxable income. For example, if your income is $50,000 and you contribute $5,000, your taxable income is $45,000. You don’t pay tax on the $5,000 until you withdraw the money.

On the other hand, a Roth 401(k) has post-tax contributions. While you won’t get a tax deduction upfront, your withdrawals are tax-free because you already paid them. However, not every employer offers a Roth 401(k). Also with both Roth and Traditional accounts, your investment income …read more

Source:: Investment You