A 401(K) is a retirement savings vehicle that enables employees to invest a percentage of each paycheck into a long-term savings account.
- 401(K) is a company-sponsored retirement plan that allows employees to contribute their income to an account where employers may match their contributions.
- Traditional and Roth are the two leading types of 401(K) plans that mainly differ in how they are taxed.
- There are maximum contribution limits for 401(K) plans that are annually adjusted for inflation.
What is a 401(K)?
The 401(K) plan is a tax-advantageous retirement plan offered by American employers. By opting into a 401(K), employees agree to contribute a proportion of each paycheck into an investment account set up for their retirement and can choose between a range of investment options that are usually mutual funds.
Employers can then elect to match the contribution partially or in whole. It must be noted that the 401(K) plan is a defined contributions plan which means that contributions have maximum limits that are set by the Internal Revenue Service (IRS). These limits are adjusted year on year for inflation.
Initiated by the US Congress as encouragement for Americans to accumulate savings for retirement, 401(K) plans have become more popular than traditional pension plans in recent years. There are two main types of 401(K) plans, Traditional and Roth, as detailed below. The primary difference between the two is taxation and employees can elect for either/both types when opting into a 401(K).
A Traditional 401(K) plan is the first available and default option when opting into a 401(K). It enables an employee’s contributions to be deducted from their gross income, meaning that 401(K) contributions are deducted directly from the employer payroll before the deduction of income taxes.
Consequently, the employee’s taxable income is reduced by the sum of annual contributions, and can be reported as a tax deduction for the year. No taxes are owed on neither the contributions nor the earnings until withdrawal (usually in retirement).
Contrary to a Traditional 401(K) plan, not all employers offer the option of a Roth 401(K) retirement plan. The main distinction between a Traditional 401(K) and a Roth 401(K) plan is that the latter invites contributions from the employee’s income after income tax has been deducted.
Consequently, no taxes are deducted in the year of contribution. Opting into a Roth 401(K) means that no further taxes are owed on neither the employee’s contributions nor their earnings upon withdrawal.
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