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What is a 401(k)?

A 401(k) plan refers to a retirement savings plan in which a proportion of an employee’s pay-check gets invested into a fund (various funds will be offered by the company). The contribution does not undergo taxation.

Deeper Definition

The 401(k) plan, similar to an IRA, can seem more attractive to savers as many employers match a portion of your saving contributions. However, the 401(k) plan must be established by the employer due to employer contributions. 

The plan comes at no extra hassle to the employee, as contributions are automatically deducted from the employee’s pay-check. The maximum annual contribution to a 401(k) is $19,500 (as of 2021), and $26,000 for those aged 50 and above.

Depending on the type of plan, the tax break occurs either when you contribute money or withdraw your retirement fund. Regardless, the employee lowers their income tax by a significant amount by contributing to a 401(k) plan and does not pay tax on any investment growth whilst the contributions remain in the fund.

401(k) example

A company may offer a 401(k) plan to their employees, allowing them to lower their income tax and increase their savings. One employee earns $60,000 a year. The employee decides to put 10% ($6000 a year) of their annual pay into their 401(k) savings plan. Each month, $500 from the employee’s pay-check will be automatically deducted, before taxes are applied, and deposited into the chosen investment fund. A list of funds will be offered by the company for the employee to decide from.

The employer may decide to contribute $3000 out of $6000 a year into the investment fund (this may differ between employers and the contributions they make). When the employee decides to withdraw money from their fund, some taxes may apply (for instance, employer contributions are pre-tax so these will be taxed when the money is withdrawn). The employer will not only gain their tax-free savings, but also their investment growth. For example, if the employee withdrew their savings after 5 years, they would have $15,000, plus any dividend gains. It should however be noted that to avoid a withdrawal penalty, the employee must be 59 ½ years old.

If the employee decided to get a new job, you can take your 401(k) with you, or convert it to an IRA.

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