If you earn high income, you should have a special retirement plan for yourself. You need to have reliable source of income in your old age and an effective retirement plan is the best way to do it. A 401(k) is a great option if you are looking for reliable savings account to save for your retirement. As opposed to a regular savings account, there are no FDIC insurance on your cash in a 401(k). That means whatever money you set aside in a 401(k), it is protected by the law.
However, most people don’t know about these plans or choose the wrong one. If you are one of those people who doesn’t know much about retirement plans or are looking for guidance on the right one for you, then read this article till the end. We will cover everything from what is a 401(k), which companies offer them and how they differ from other plans offered by different companies.
Table of Contents
What is a 401(k) and Why You Should Have One?
A 401(k) is a retirement plan that has many benefits. The most common benefit is that people can invest in the company’s stock or bonds. If you have a 401(k), you need to be careful with your investments because they are all tax-deferred. A 401(k) gets its name from section 401 of the Internal Revenue Code (IRC). This also helps avoid paying taxes on your early withdrawals.
In short, if you want to make sure that you’ll have enough money later on, then you should put some money aside into a 401(k).
Types of 401(k)s
There are two types of 401(k)s. One is the Roth 401(k) which you contribute pre-tax and the other is a traditional 401(k) where you contribute after-tax income. It is important to understand the difference between these two plans as they have different tax implications.
The key difference between a Roth 401(k) and a traditional 401(k) is that in case of the former, your contribution won’t be taxed at all when it comes out. And since taxes are already taken off when you make your contribution, there is no need to worry about making it up later on with extra taxes. That’s why people who make high income might want to go with a Roth account even though they may be offered a traditional plan by their employers.
In an employer sponsored plan, your company invests your money for you. In contrast, with a self-directed plan like a Roth account, you will have to invest yourself – meaning you will have to pay some fees on the way to building your nest egg.
So what should you choose? If your employer doesn’t offer a self-directed option for retirement savings, then our advice would be go for the Roth account because it offers more flexibility and control over how much money goes into each individual investment option and how long it stays invested in those investments instead of getting stuck in one particular company’s stock options or funds or other investment products that may not be the best for your portfolio development needs at
Defining Features of a 401(k) Plan
The 401(k) is a retirement plan that allows you to open an account with your employer and make contributions up to $18,000 per year in 2018. It also lets you contribute an additional $6,000 if you are 50 or older.
Your 401(k) has tax free growth for the first six years and then it will be taxed at your ordinary income rate. Most companies offer a match on your contribution but others have a high limit on their match. You can also invest in mutual funds or stocks with your 401(k).
If you work for a company without any retirement plan, you can use your 401(k) when leaving the company. But if your employer offers a retirement plan that provides a better deal than what the government requires, then it would be best to stay with the one where you are matched.
In case of death or disability of the owner, this plan will continue to pay out to beneficiaries as long as they stay with the same company.
Advantages of a 401(k) Over Regular Savings Account
The 401(k) is a retirement plan that allows for tax-deferred growth and contributions are pre-tax. That means you save money on taxes, which can be saved or invested in the account. Additionally, the 401(k) offers various company benefits like company match, health insurance and life insurance.
Other advantages of a 401(k) include having multiple investment options and lower fees than other plans. For example, you can choose between a wide range of mutual funds offered by your company as well as within employer-sponsored plans. With other plans, you may be limited to only investing in stock or bond funds at higher costs. Furthermore, the cost of services provided by your company may not be worth using this plan over the other one because there is no way to compare them.
Disadvantages of a 401(k) Plan
A 401(k) is a type of tax-deferred retirement savings plan. With this plan, you are allowed to contribute pre-tax income or money that has already paid taxes. This means that your contributions are not taxed when you first contribute them to the account and the contributions grow over time tax-free. If you want to withdraw part or all of your funds before you retire, you will be taxed on the amount withdrawn.
However, this plan does have its disadvantages as well as advantages. One disadvantage is that it only allows for a set amount of contributions each year which may not be enough for some people’s needs. Another disadvantage is that there is no FDIC insurance on your cash in a 401(k). Unlike normal savings accounts, if anything happens to ruin your 401(k), there is no backup plan after taxes, withdrawals and fees are accounted for. Lastly, there are several other plans that can be considered instead of a 401(k), such as SEP IRA and Simplified Employee Pension (SIPC).
Conclusion
A 401(k) plan is a form of retirement savings plan in which you buy a piece of retirement income for yourself. The advantage of a 401(k) versus a regular savings account is that your contributions are pre-tax. A 401(k) also offers the ability to defer taxes on your contributions until the money is withdrawn.
Additionally, if you are fortunate enough to make more than the 401(k) contribution limit, then you get an even better deal. You get to contribute the additional amount over and above the 401(k) limit as well as pay taxes on it now at your current income tax rate rather than when you retire.
FAQ’s
What is a 401(k)?
A 401(k) is a type of tax-deferred investment account (i.e., a plan that allows you to contribute to your taxes),targeted at employees of US companies, where your contributions tax-deferred and your earnings tax free (without declaring it as income). The 401(k) helps to save for retirement by deferring taxes on both the employee and employer contribution. The contribution limit for 2017 is $18,000. In addition to the contribution limit, there is an annual contribution limit in 2017 which is $50,000. The 401(k) also provides tax deductions for both the employee and employer on their respective contributions.
Every year after contributing the funds into the 401(k), you will receive a Form W-2 as well as a 1099 tax form in which you can claim the deduction. Despite being a tax deferred vehicle, your earnings are subject to federal and state (dual) taxation. This means that you will have to pay taxes on earnings even though they are protected from taxes by being inside the plan. It’s important to understand that while accounts inside the plan tend to be more tax efficient than traditional taxable accounts, they’re not completely tax deductible. At this time it’s not clear if 401(k) balances at death are included in your estate for inheritance tax purposes (it might or might not). Due to these limitations and other pitfalls such as limited liquidity, low access after leaving the company and high cost of transactions, many people choose non-401(k) plans such as roth IRAs or SEPs . However despite its drawbacks, there is still no replacement for 401k in terms of simplicity and security for saving for retirement.
What are the benefits of a 401(k)?
The best benefit of a 401(k) plan is the tax deduction.
A 401(k) plan is a defined contribution plan that allows the employee to set aside a portion of their earnings for retirement. This contribution, or employee deferral, is tax deductible to the employee up to the annual contribution limit (as described below), and sheltered in a qualified retirement account to which no taxes are withheld.
The tax benefits of this strategy are two-fold: first, employees can deduct their contribution from their income and it shows up in their taxable income, lower than if they set it aside in a taxable account like a brokerage account. Secondly, because it’s tax deductible, even though there is income from Social Security and Medicare at the time of distribution, this income also shows up in your taxable income and can’t be offset by other deductions.
There are additional tax benefits to 401(k) plans, such as: deferral of current taxes on contributions and earnings, no required minimum distributions in retirement, and lower taxes on qualified distributions (although this may gradually change).
What are the drawbacks of a 401(k)?
The biggest drawback of a 401k is that your company will take a large portion of your paycheck. This is to help fund their 401k. Because of this, you will likely have to boost your income in order to qualify for any investment gains.
Besides this, the 401k isn’t much different than a regular savings account, the only major difference being that the funds are protected by FDIC insurance. If something were to happen to the company who manages your 401k, then you would still be able to access your money. This is not the case with a regular savings account.
While both these accounts offer tax-deferred growth and may help you meet your short-term financial goals, long-term investing needs tend to be better suited for an IRA or 401(k) rollover.
Lastly, there is always the concern about fees and performance charges when investing in a 401k. While there are some low-cost options available, most brokers will charge something for their services (usually 1% or lower).
