A 401(k) allows employees to save pre-tax dollars into an account that grows tax-deferred. The plan offers a variety of investment choices. Employee-directed contributions are immediately vested, but many companies set vesting schedules that require employees to remain at the company for two or more years before employer matching or other funds become theirs.
Contributions
How does a 401k work? With a 401(k), you choose a percentage of your paycheck to be automatically invested in your account, and your employer might match some or all of your contributions. This investment grows tax-free until you retire, giving you time to build a substantial nest egg. A 401(k) contribution match is a popular employee benefit that can make an employer stand out when recruiting and retaining talent. Depending on the plan, it may be written as a percentage of an employee’s salary up to a certain amount or a dollar limit. Some programs offer target-date funds designed with the employee’s anticipated retirement timeline. The more time the money has to grow, thanks to compound interest (interest earned upon interest), the more it can snowball – eventually lowering the out-of-pocket retirement costs. It’s worth noting that employer matches do not count toward the annual contribution limits, currently $22,500 (plus $7,500 in catch-up contributions for those over 50).
Matching
Employers can contribute extra funds to their employees’ 401k accounts. This is known as matching contributions, and it can effectively motivate employees to join the program. The amount of the match provided by the company is based on the employee’s total compensation, not only the amount they defer to their account. The specifics of a company’s matching formula vary, but most follow a basic formula that matches the employee’s contribution dollar-for-dollar up to a percentage of their total salary. Some companies also offer a flat rate match, contributing the same amount to every employee’s account regardless of how much they save. A 401k matching contribution is typically only included in an employee’s gross income once it is distributed in retirement. This means it escapes the employer and employee portions of FICA and state and local income taxes. In addition, if the company match is invested the same way as an employee’s investments, it can earn even more returns, or “returns on returns,” over time. In the competition for top talent, a 401k with a matching contribution can be an attractive part of an employment package, especially when other employers may not offer it. However, employees must understand how a company’s matching plan works and ensure they save enough to qualify for the maximum benefit.
Rollovers
In a 401(k) plan, you can have a percentage of your paycheck go directly into an investment account. Your employer might also match some of that contribution. The investments in your plan can be made up of various mutual funds, stocks and bonds. Some programs automatically put your gifts into “target-date” funds, which are mutual fund portfolios that automatically change to increase their amount of stocks as you get closer to retirement. You can always opt out of this option if you want to manage your investments. If you change jobs, you can roll your old 401(k) into a new employer’s plan or an individual retirement account (IRA). Some providers try to make the process as simple as possible by offering direct rollovers, but you should still be aware of potential issues that might arise. These issues include possible taxes and penalties and a provider’s tendency to withhold more than you might owe. If you have company stock in your 401(k), you may not roll it over because of the tax liability on any net unrealized appreciation. This is the difference between what you paid for shares and their current value. You can avoid this tax by paying the taxes upfront, or if you choose not to do so, it becomes your taxable gain when you take a distribution from the account.
Taxes
An employer can choose to contribute to its employees’ 401k plans in addition to matching employee contributions. These contributions are made pre-tax and can be invested in several investment options the plan administrator provides. 401k plan providers may also offer “target date funds,” designed with a retiree’s timeline and investing goals in mind and might have riskier asset allocations to start, becoming more conservative as the employee gets closer to retirement. Employees can choose which investment options to use, which are usually mutual funds. Employees can change their contribution amounts whenever they like, although increasing the amount they save over time is a good idea, especially when they get a raise. It’s also possible for employees to transfer their 401k accounts when they leave an employer. Those transfers are typically tax-free, but the money in a former employer’s account is still subject to income taxes when withdrawn. Lower- and middle-income workers might be eligible for a Saver’s Credit to offset part of the first $2,000 they save in their 401(k) plan. As competition for qualified talent intensifies, offering a 401(k) plan and matching employer contributions can be a key differentiator in hiring new employees. In addition to the obvious financial benefits, a 401(k) plan can help employers attract and retain a talented workforce by making it easier for employees to save money through a tax-advantaged savings vehicle.