What is a 401K?

A retirement account that allows you to divert part of your salary into a long-term savings or investment account is known as a 401K. Your employer often matches the amount you set aside for each contribution up to a specified limit.

This investment account is a qualified retirement plan, so you are not taxed on your contributions or the balance on the account. To receive this special tax benefit, the plan has to qualify under IRS guidelines. There are two qualifying plans:

  • Defined Contribution
    • The 401K and 403B are typically defined-contribution plans. These plans are where you contribute a fixed amount, or percentage of your paycheck to an account you plan to use for your retirement. Your employer will often match the amount you’ve selected as the contribution. Some restrictions control how and when you can withdraw from your account without paying penalties. Some of the key factors defining the defined contribution are:
      • The 401K is a defined-contribution plan intended for you to use after retirement. You can invest pre-tax dollars into capital markets which can grow until your retirement and you do not pay taxes on the money.
      • 401K and 403B plans are often used by employers as incentives for their employees to save money for retirement
      • With the defined contribution, you have no guarantees, and your participation is self-directed and voluntary
  • Defined Benefit
    • A defined benefit plan is an employer-sponsored retirement plan. Your benefits are computed by a formula with several factors considered including your salary history and length of employment. The defined benefit plan is different from other retirement accounts as the payout will depend on investment returns. If there are poor investments made or faulty calculations, it will result in the account falling short on funds. If the account falls short, the employers are legally obligated to make up the difference. Some of the key factors defining the defined benefit are:
      • The plan is employer-based and pays benefits based on salary history and length of employment
      • Your pension is considered a defined benefit plan
      • Employers are responsible for all investments and planning
      • Benefits can be paid out as an annuity, lump sum. or fixed monthly payments
      • The employees surviving spouse is entitled to the benefits if the employee passes away
      • The employer assumes all risks as they make the decisions regarding which investments are made

Limits on Contributions for 401Ks

Each year, typically in October or November, the IRS will review the maximum contribution limits for 401Ks. These are some of the updates made by the IRS for 2021 contributions:

  • For the year 2021, employees can contribute up to $19,500 to be invested into their 401K
  • If you are over the age of 50 you are eligible for additional catch-up contributions of $6,500 in 2021
  • The general limit on employer and employee total contributions for 2021 is $58,000, or $64,500 with a catch-up contribution

Rules for Taking Money Out of 401K

The distribution of money in a 401K plan is different from those applied to IRAs (Individual Retirement Account.) An early withdrawal of your assets from either of these accounts will increase the income taxes you’ll have to pay at the end of the year. There may even be a ten-percent penalty if you are under the age of 591/2. You don’t need a rationale to withdraw money from an IRA, but with a 401K one of the following must exist:

  • You have left your job or retired
  • You have become disabled or passed away
  • You have reached the age of 591/2
  • You experience hardship as defined under the plan
  • The 401K plan is terminated

With the right financial advisor, you can use your 401K to reach long-term financial goals. For most people, Social Security will not be enough to meet financial needs once you retire. Having a 401K plan could make a significant difference in your financial stability in your later years.

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