What is a 401(k) plan? Is this the best plan for me?
History of the 401(k) plan. The 401(k) plan is named for the section of the tax code that governs it. The rules established in the Revenue Act of 1978 made it possible for employers to create tax advantaged savings accounts for their employees, but it was not until 1981 that the IRS modified Section 401(k) to allow for a separate account to be set up and funded through salary reductions and in 1981 the IRS complied. By 1983 over 7 million employees participated, by 1991 over 48 million were participating. In 2001, congress passed Economic Growth and Tax relief reconciliation act, allowing for “catch up contributions” for participants aged 50 years and older.
401(k) Defined. The IRS describes a 401(k) plan as “a feature of a qualified profit-sharing plan that allows employees to contribute a portion of their wages to individual accounts… Elective salary deferrals are excluded from the employee’s taxable income (except for designated Roth deferrals).” In other words, employers can set up a savings plan for their employees, which allow for pre-tax contributions (salary deferrals) from the employee and from the employer’s contributions. The tax is not incurred until the funds are distributed upon retirement. It is important to note that your employer is the party who establishes the plan, but you can affect who contributes. Per the IRS, employees are due 100% of their salary deferrals (less taxes or early withdrawal penalties) but employer contributions may be vested on a graduated schedule. A 401(k) offers flexibility of contributions. Employees may make higher contributions in a year than under IRA plans; $18,000 in a 401(k) or $12,500 in a simple 401(k) compared to $5,500 in a Traditional IRA in 2016. That’s the good news. This may mean higher administrative costs to employers. 401(k) plans are a good match to businesses with cash flow challenges. Optional hardship loans are available to employees. This additional withdrawal and loan flexibility means more administrative costs/burdens on the employer. Also, complicated testing must be performed to verify that benefits do not discriminate in favor of the highly compensated employees. .
If your employer offers a 401(k) plan and matches your contributions by any percent, it can be a good savings tool, loaded with lovely free money, and tax deferred until you actually receive it as income. At 25 or 30 years old, retirement can seem so far away, but if you don’t begin the savings now, it can be very difficult to catch up later. Setting the money aside can save you taxes on your income, and you retirement funds get even more boost with employer contributions! Contact us today to speak with an investment advisor to figure out how to plan for your future. .