What Is a 401(k) Plan?-Limitations, Benefits, Roth 401(k) Contributions, 401(k) Rollovers


Like most young professionals, you may probably view retirement savings as one of your least priorities―in fact; you may not even see it as a priority at all. You may also see it as something unnecessary and a burden. However, without retirement savings, your only income will be from your Social Security, which might not be enough to live on, and it might not also have the same value as today in the future. If you want to secure your retirement, it is encouraged that you get a 401(k) plan. With this plan, your company will match you with a percentage of your 401(k) contribution.

What Is a 401(k) Plan?

Similar to a savings account, a 401(k) is an account where you put money that you set aside to use it when you retire. Your contribution grows over time, and once you retire, you can already use it. Your 401(k) is also considered as a retirement plan. This plan is sponsored by the employer who is responsible for deferring money from the paychecks of their employees to their individual 401(k) accounts and invest it.

How Does a 401(k) Plan Work?

Through 401(k) plans, eligible employees of a company get a retirement plan that allows them to save and invest for their retirement. This plan is on a tax-deferred basis. Employers are the only ones who can sponsor a 401(k) plan for their employees. Employees can decide how much money to be deducted from their paychecks and to be deposited to their plan. However, there are still some limitations. These are:

Employers can also give a contribution to the plans of their employees, but this is already under their discretion. Employers are also responsible for running the 401(k) plans of their employees by following the laws, rules, and regulations, and provisions of the 401(k) plan.

Limitations of 401(k) Plans

Having a 401(k) plan is important in order to achieve portfolio optimization. However, 401(k) plans have limitations, and you might find about it when you will conduct a financial risk analysis. Among the limitations include:

  • Limited amount to be deposited: There are limitations when it comes to the amount of money you can deposit into your 401(k) accounts. For employees of ages 49 and below, they cannot contribute more than $17,500. If employees are over 50 years old, the limit is at $23,000.
  • Withdrawal requirements: Sure, you can withdraw from your 401(k) plan once you retire; however, there are limitations such as required withdrawals as soon as you reach the age of 7070½.
  • Long waiting periods: Even if employees have the right to getting a 401(k) plan, it will take a long period of time before they can initiate such plans with their employers. The waiting period can go as long as six months and even up to a year.
  • Taxable once withdrawn: Once a plan holder retires and starts to withdraw money from his or her 401(k) plan, the money he or she withdraws is taxed as additional income. While the plan holder can withdraw from his or her 401(k) plan before retirement, the taxation can reach up to 20% along with a 10% penalty if it is withdrawn by the plan holder before he or she reaches 5970½.

Benefits and 401(k) Contributions

401(k) plans are undeniably attractive, most especially that it comes with various benefits. It five key benefits are:

  • Tax advantages: Regular contributions to an employee’s 401(k) plan is on a pre-tax basis, which means that your 401(k) earnings are accrued on a tax-deferred basis. Because of this, the amount you contribute to your plan are exempted from your current federal income tax, lowering your taxable income for the year in the process.
  • Employer matching programs: There are employers who would offer their employees to match the amount they contribute to their 401(k) plan, and there are some employees who would include a profit-sharing feature that enables an employer to get a portion of the company’s profit and contribute to its employee’s 401(k) plans.
  • Continued contributions: Even if you are still working after your expected age of retirement, you can still continue to contribute to your 401(k) plans. Other retirement accounts such as the traditional IRA would no longer allow you to contribute as soon as you reach the age of 70½. In the process, you also get spared from taking mandatory distributions.

Roth 401(k) Contributions – Pre-Tax or After-Tax

Roth 401(k) contributions make use of after-tax dollars―this basically makes such contributions the opposite of pre-tax contributions.  It is ideal to make your Roth contributions when your earnings and the applicable tax rate is not that high. Roth 401(k) does not include income limits, which makes any employee choose this account whatever their income might be. Roth 401(k) contributions are also not taxable at withdrawal and earnings are tax-free once withdrawn, particularly if they are part of a qualified distribution.

401(k) Investment for Beginners

401(k) investments are a great choice for new investors since most 401(k) plans offer a target-date fund that can be matched to the approximate year of their retirement. However, beginners should know that a 401(k) plan is not a type of investment―it is a type of a tax-advantaged account that holds investments, such as mutual funds.

401(k) Rollovers

Starting out on a new job and that you want your present employer to run and manage it? Then rolling your 401(k) over into your new employer’s plan is an option you should consider. If you want a safe option, consider a direct rollover where your current 401(k) plan administrator will make a direct payment to your new employer’s 401(k).

Vested 401(k) Balances

Your 401(k) plan is part of your investment portfolio, so make sure that you still have it even if you change employers. Another thing you can consider aside from 401(k) rollover is vesting, which can serve as your balanced investment strategy in order to fully maximize your 401(k) balance. Vesting basically means ownership where all of the contributions you made to your 401(k) account are immediately and 100% vested, or owned, by you alone and this is your vested 401(k) balance which is the amount you keep if you stop or change employers. On the other hand, the contributions made by your employer to your 401(k) is still subject to vesting rules and schedule.

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