401k plan what you should know and how it works
July 19, 2021
401k plan – There’s this need to safeguard one’s future financially to live a stress free-life having retired from active employment, there’s a life after work, and the earlier you put this in perspective the better for you afterward.
Here’s a guide to putting you through the 401k plan, what it is, how it works, the employer matching contributions, limits, and withdrawal, etc.
What is a 401k plan all about?
If you are new to the work environment or an employee, it’s not out of order to ask or inquire into the concept of this financial planning.
Definition: 401k plan is a contribution an employer makes given an employee’s retirement, the contribution is targeted at giving the employee a safe retirement financially.
For example, most employers include this plan in their offer letter before an employee resumes with such an employer, it’s called an added advantage/package.
Relatively, if as an employee you want a 401k plan inclusive job offer, nothing stops you from discussing and making inquiries into it before you sign the dotted lines in the first place.
However, as an employee, you may choose to offer a fraction of your earnings/wages towards funding the 401k account progressively which is ideal and commendable.
An employee has the express right to go ahead with investment if they choose to invest the funds saved in the 401k account in certain mutual funds offered by the supposed plan, why would you invest? This is to provide more income opportunities at your old age of course.
The benefit that comes with an active 401k account cannot be underscored,
- It enhances savings at source: This is found to be one of the most effective ways to save since that’s on top of your priority before you access the fund even.
- Direct control of investment/contribution: In this account, you have the express right to decide how much you wish to contribute. Depending on your future financial goals and current budget you may contribute aggressively especially when age is ticking out.
- It’s flexible and transferrable: Have you asked what could happen to your 401k account if you eventually leave/resign or change your initial employer? All funds contributed and initial earnings accrued belong to you expressly, so there’s no case of losing or forfeiting your contribution at the instance of resigning/walking away from your initial employer.
- No tax deduction: If you contribute to a 401k account, your tax liability becomes low with the relative advantage since the amount contributed is not taxable by law. Income is taxed after your contribution has been deducted strictly for a traditional 401k account, while Roth is post-tax.
How 401k plan works
Traditionally an employer could choose how much he/she wants to contribute to the 401k account annually, such amount is deducted from the paycheck before tax.
Assuming you receive a monthly salary of $1000 and decides to contribute $200 into the 401k account your taxable income is then $800.
This may vary where you choose a Roth 401k, in this case, your monthly contribution of $200 will be deducted after taxes, where the employer could match some or all of the contributions made.
However, the investment is not taxed until an employer withdraws from such account which happens after retirement wherein withdrawals may not be taxed where an employee enrolls in a Roth 401k plan.
Types of 401k accounts
There are two types of 401k accounts whose major differences lie in how they are being taxed.
- The traditional 401k account and
- The Roth 401k
The traditional 401k account: This is a pre-tax account, in this case, the employee income is taxed after the percentage monthly contribution into the account has been made.
On withdrawal after retirement which is the ultimate purpose of this account, an employee is taxed.
The Roth 401k account: Here is a post-taxed account, the income is taxed before the monthly contribution is made expressly from the employer’s payroll to the employee’s account.
The employee may not be taxed on this account on withdrawal.
This refers to the threshold or maximum amount an employer/employee can contribute to the 401k plan, this amount is adjustable periodically given inflation year in and out.
For example, the 2020 and 2021 basic limits on employee/employer contributions stood at $19,500 annually for employees under 50, while $26,000 goes for contributors who are 50 and above with a $6,500 catch-up contribution.
This initiative was designed to provide income for the employer on retirement. The IRS rule prevents an employer from withdrawing from the 401k account, where such withdrawal is made, it must be accompanied by a penalty upward of 10% of the withdrawal amount and 20% income tax if you are not up to 59 and half years.
However, there are exceptions to this rule which include
- Withdrawal for medical expenses
- Withdrawal based on permanent disability
- Withdrawal by personnel in certain military service
- In a situation, an employee leaves the employer at 55 or more years old
- Where a Qualified Domestic Retirement Order is been issued as part of a divorce or court-approved separation.
Note: Evading taxes on these conditions does not imply that you’ll not pay tax for withdrawing from a traditional 401k account.
Loan against 401k account
An employer may apply for a part of the contribution being made as a loan to help one stay on track with financial demands.
However such loans can only be accessed on certain bases and conditions according to the rules.
Rules on 401k loan
It is expected that the maximum amount you will take a loan from your 401k account should be 50% of your vested account balance, or $50,000 whichever is less. However, if 50% of the vested amount is less than $8000 you may borrow up to $8000 provided the plan gives room to that.
To proceed, all loan applications must meet the below requirements
- There must be a written loan agreement for each loan
- For plan loans, there’s an interest rate charged, however, this interest is returned into your 401k account on the payment
- You must not borrow more than a pre-determined set amount
- All loans must be repaid within 5 years, except used for mortgage/purchase of a residence
- Repayment is made in installments quarterly in equal payments which should include repayable principal and the interest.
401k plan is an employer/company-sponsored retirement account on behalf of the employee, which the company can make a matching contribution.
Ideally, it’s either an employer who goes for the traditional 401k account or the Roth account which has taxes applied at different points.
While the traditional 401k account is pre-tax-based, the Roth is a post-tax account.
The former charges tax on withdrawal, while the latter may not involve tax, however, an employee has the express right to choose the desired plan according to the provision of the company which usually is an added package/employment benefit.
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