A 401(k) is a tax-favored investment account that allows an employee to save for retirement. These employer-sponsored plans allow an employee to contribute to the fund by directing a portion of their salary towards it, similar to deferred pay. The money added does not get taxed until it is withdrawn in the future. Additionally, many sponsoring companies will match the employee’s contributions up to an absolute limit, which is usually anywhere from 3%-6% of an employee’s annual salary. For these reasons and more, the 401(k) has been adopted by countless businesses and gives millions of employees a better way to save for retirement.
When Was the 401(k) Introduced?
The 401(k) plan has been one of the most popular retirement plans since its inception in 1978. It is based on a section of the Retirement Act that served as a response to the ways business executives were taking advantage of tax-deferred arrangements. In short, these are arrangements in which company stock, cash, and other assets are vested over periods of time by employees. This allowed for several perks that the government wanted to quell.
The Retirement Act of 1978 set the foundation for companies to start implementing retirement plans based on its contents. Ted Benna, the current president of the 401(k) association, was the first employer who decided to create such a plan. He used his interpretation of these laws to create a system where his employees could defer part of their pre-tax salary into a savings or investment account, while also allowing him to match some of their contributions. After seeing the success of his plan, he asked the IRS to consider new rules to allow for more adoption of this plan. The IRS agreed with his sentiment, and the rest is history.
As mentioned before, the 401(k) allows employees to direct some of their pre-tax salaries into a savings or investment account, where it is matched by their employer by 3%-6%. So for example, if you were making $50,000 a year, and your employer matched 3% of that, that means if you invested $1,500 of your salary, your employer would also contribute $1,500. Some companies allow the employee to have control of what fund the money gets added to, but in most cases, the employer creates a fund or uses an existing one that is low-risk and almost guaranteed to grow over the long-term.
Besides the company matching an employees investment, the other benefit is potentially paying lower taxes. When you invest some of your salaries into a 401(k) plan, you are spending pre-tax dollars as opposed to earning money, getting taxed on it, and then investing separately. You are, however, taxed on this money when it is withdrawn from the account, but that almost always results in lower taxes than it would have been.
All of these characteristics of the 401(k) plan make it a very enticing option for employees to opt into. So why don’t they go all in and just invest the majority of their salary?
401(k) Restrictions And Limits
Without any restrictions or limits, the 401(k) plan would become so popular that there would be less money going into other funds and investments, and this could hurt the financial markets as a whole. Because of this and many other reasons, there are rules and limits to how much an employee can put into a 401(k) each year, how much an employer can match, and when an individual can withdraw the money.
The limit for the amount that can be added to your 401(k) in 2018 is $18,500, and another $6,000 if the you are over 50 years old. The matched dollars by the employer also contributes to this amount. There is also a limit to how high the salary can be when the percent match is applied. This maxes out at $270,000, which means that the percentage matched can only be used to a maximum of $270,000, even if the employee is making more.
Lastly, there are rules for the fund’s withdrawal. To realize the full benefits of your 401(k) plan, you must wait until you are 59.5 years old to withdraw. You can also withdraw if you leave your employer at the age of 55 or older. If you decide to take the money out before this age, you will receive a 10% penalty on top of the average tax bill.
An Effective Retirement Plan
All in all, the 401(k) is a very practical and safe retirement plan. Employees should try as hard as possible to max out their contributions each year so they can gain as much value as possible. With the tax benefits and company matching, the 401(k) is not something to shy away from.