It’s difficult to imagine a retirement plan without a 401(k) account, but in reality they have only been in existence for 30 years. A traditional 401(k) is a retirement savings plan, usually sponsored by an employer, which allows a person to save for retirement by having their savings invested. This savings tool defers income taxes for the employee on both the money saved and its earnings until the funds are withdrawn. With a 401(k) sponsored by an employer, a worker will normally have a percentage of their gross pay deducted automatically from their paycheck, making this retirement savings plan even more attractive.
As an added benefit of a 401(k) plan, many companies provide matching funds to an employee’s contribution. Often these matching funds are based on the number of years the employee has worked for the company. The catch is that many employers will phase in a vested percentage of the funds as employment continues, to encourage employees to stay with the company. The vested percentage means that only that portion of the company’s matching funds belong to the employee. After many years of employment a worker may become 100% vested.
For example: John makes $50,000 annually and elects to contribute 10% to his 401(k) account. His employer provides a 1% match that is 20% vested after 5 years of employment. In this case, John’s employer contributes $500 annually to his 401(k) for a total of $2,500 after five years. If John resigns after five years, only 20% or $500 of the employer contributions remains in his 401(k). Any contribution that John makes is not affected, only the employer’s contribution.
While a 401(k) plan is tax deferred, it is not tax free. When withdrawals begin, normally after retirement or after the age of 70-1/2, the withdrawals are taxed as income. The tax benefit depends on the theory that your retirement income is lower than your working income, thus the taxes will be lower.
Of course, there are many aspects of a 401(k) savings plan you should be familiar with, so it always helps to consult with a qualified financial planner before making any investment decisions.