How Does a 401(k) Work?
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The 401K in a Nutshell
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Social Security is not, and was never intended to be, a full-solution retirement plan, so supplemental retirement savings are crucial. Many employers have pulled back on funding pension plans, so individual retirement plans have become crucial to many people's retirement plans. For many, a 401(k) plan is the best option available for personal retirement investing. A 401(k) is a retirement investment plan offered through a place of employment. It is up to the employee whether they wish to join the plan and, if they do, how much they wish to contribute. The employer decides whether or not they wish to contribute to the plan.
How it Works for the Employer
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Employers offer 401(k) plans as a means of attracting quality employees to work for their company. It is also a means of instilling company loyalty within existing employees. If the plan is a good one, it may encourage current employees to stay with the company for a longer period of time -- or even for life -- as they believe it will be beneficial in their retirement years. The employer's onus is to obey the federal regulations that govern 401(k) plans, and to contribute to the employee's funds if they have agreed to do so at the outset. Employers decide which investment firm to go with to provide investment options in their plans, and they may or may not take a direct interest in the type of investments they allow the employees to take part in.
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What is Needed From the Employee
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If the employee decides he or she wishes to take part in their company's 401(k) plan, they must decide how much they wish to contribute from their paychecks each week (or month, depending on how often they are paid). Once this decision is made, it is typically set in stone for about a year. Then the employee will be able to change the amount if they so choose. By contributing to the 401(k), the employee will be able to lessen the income tax they currently pay. All 401(k) contributions are tax free, up until the time they are removed from the account.
This, for employees, is the key benefit of a 401(k) plan. All contributions are tax free at the time they are made, and all investments can grow tax free inside the plan until they are withdrawn after age 59 1/2. If the employer decides to contribute matching dollars to the fund, so much the better -- this money, too, is tax-free to the employee and can grow tax free until it is withdrawn.
Make the Most of Your Plan
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Employers are required to give their employees a full plan summary detailing every part of their 401(k) plan. If you are currently enrolled in such a plan, or are thinking about it, it would be in your best interest to read this summary carefully. In addition, many people make the mistake of dipping into their 401(k) plans too often. Many employers allow employees to take loans from their plans. In general, if the money is repaid within five years, plus interest, no penalties or taxes are owed, but most employers who offer loans will prohibit employees from making more contributions to the plan until the loan is paid off, and the money that is borrowed is not invested and earning more in the meantime. Early withdrawals may be allowed from a 401(k) for specific reasons, such as an education expense or a first-time home purchase -- but a 10 percent penalty and taxes will almost always be due upon withdrawal if the money is taken out before age 59 1/2.
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