What is a 401(k)?

A 401(k) is the best option for saving and investing in your retirement. Learn how they work and why you need to start contributing today.

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The Basics of a 401(k)

A 401(k) is a retirement account sponsored by an employer. It is named a 401(k) because of the tax code that governs them. A 401(k) allows an employee to withdraw part of their paycheck, before taxes, and invest it. The money is not taxed until the account is cashed out.

Some Background on the 401(k)

Back in the early 20th century, it was common for employers to simply offer a pension to their employees after they retired. Unfortunately, as the life expectancy and population increased, employers realized they could no longer afford to pay those pensions. So, in 1978, a law was passed to allow the creation of 401(k)’s.

The Investment Company Institute, 401(k) accounts have over $5.7 trillion in assets in the United States. It is now the most popular form of a retirement account and continues to grow each year.

How a 401(k) Works

Again, a 401(k) is an employer-sponsored retirement plan. Before taxes are taken out of an employee’s paycheck, they can opt for an amount of that money to be taken out and put into a 401(k) account. Most employers will match contributions up to a certain amount, usually 5-8%, meaning you are basically earning free money.

A 401(k) is not taxed until it is cashed out, meaning you don’t need to worry about paying the taxes on your investments as they grow until you’re ready to withdraw the funds.

There is another option recently established in 2006 called a Roth 401(k). This works in reverse of a traditional 401(k). A Roth account allows an employee to use after-tax dollars to put into their 401(k) account, so when it is withdrawn, you don’t need to pay taxes on it.

401(k) accounts consist of investments, such as stocks, bonds, and other money market investments. These accounts are usually managed by a third-party investment firm, called administrators.

You can contact your administrator to receive updates and information on your account. You can also make adjustments on how your account is managed and hot to move money around based upon your investment preferences.

As of 2019, the maximum contributions to a 401(k) account are $19,000.

Restrictions on 401(k) Accounts

Due to their nature, the IRS imposes a few restrictions on 401(k)’s. An individual cannot withdraw from their 401(k) account before the age of 59 ½ and while they are employed with their sponsoring company. Breaking these conditions will result in harsh penalties, such as an excise tax or duty of 10%.

Account owners are required to make distributions from their accounts by April 1 following the age of 70 ½ or after they have retired, whichever is later. There are a few exceptions, such as those who are still working.  A Roth account is not subject to minimum distributions, and penalties for not meeting minimum distributions is 50% of the amount required.

Conclusion

With the ending of retirement pensions and the likelihood of people living longer and healthy lives, the need to invest in retirement is more important than ever. A 401(k) is the best option to do just that, with minimal difficulties and an easy to use process, any working person should look to contributing as much as they can to a 401(k) account.

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