What is 401K

401K

All about 401K – Is the most popular employer-sponsored retirement plan in the United States.

The 401k is an effective profit-sharing plan.

The name 401 comes from the the section of the tax code that governs it.

A profit-sharing plan, also known as a deferred profit-sharing plan (DPSP) is a plan that gives employees a share of the profits of a company.

We will cover everything you need to know about 401k in this article.

What is 401k

The 401k feature is effectively a retirement plan sponsored by the employee’s employer.

It allows employees to invest their paychecks before taxes are taken from taken. The worker can invest a monthly amount, that is automatically deducted from their paycheck.

The Internal Revenue Service (IRS) limits how much you can invest in 401k. The maximum amount you can invest in 401k changes every year.

The limit imposed on 401k investments is called the elective deferral limit (EDL). The contribution limit for 401k in 2018 is $18,500.

However, citizens 50 or older who expect to reach the EDL can add 6,000 to their contributions, raising the maximum investment amount to $24,500.

Tax benefits for 401k

There are many benefits for adopting a 401k plan; it allows you to pay taxes in a totally different manner.

The percentage with which you contribute accumulates on a pretax basis. Which is to say, your contributions will be exempted from the current federal income tax.

Moreover, besides lowering your taxable incomes, your earnings accumulate on a tax-deferred basis.

Which is to say, the dividends and capital gains earned within your 401k plan are not subject to taxes until you start withdrawing from them.

Important to note, since your taxes accumulate on a tax-deferred basis, is better for you not to withdraw from your savings before retirement.

The reason for that is that when you retire you will be on a lower tax bracket, which means you will pay less taxes on 401k withdrawals.

You are probably going to be on a lower tax bracket after retirement because retired citizens usually earn a lower income after their retirement.

Match contribution benefits

Your employers can offer matching contributions to your 401k plan, and they can also add a profit-sharing feature to your plan.

What that means is that if your entreprise offers you a matching contribution, they are basically offering you free money.

Generally, employers offer to contribute 50 percent of the first 6 percent you contribute to a 401k plan.

Depending on how much of money you receive monthly, this contributions can amount to a thousand or more easy money.

The amount of contributions you will receive depends on your salary and on the percentage of your own contributions that the employers will pay.

Lifetime contributions benefits

The 401k plan has this unique characteristic that allows you to contribute for as long as you want before you withdraw from your savings.

The only requirement is that you have to be working while you contribute.

Most other Individual Retirement Accounts don’t allow you to keep contributing for your retirement benefits after you are 70, even if you are still working.

Shelter from creditors benefits

The 401k plan is a special plan because it was established under the Employee Retirement Income Security Act (ERISA).

And ERISA accounts are usually sheltered from creditors, even judgment creditors.

A judgment creditor is a creditor that has proven his debt legally and is entitled to use a judicial process to collect the debt.

Additionally, the 401k also offers shelter from federal tax liens. A federal lien is a federally authorized lien against someone who hasn’t paid taxes.

The reason why it is hard for the federal liens to affect your savings is because the 401k plans officially belong to your employer.

Roth 401(k) Option

The Roth 401k is an option for the traditional 401k plan; it combines the traditional 401k plan with a Roth Individual Retirement Account (IRA).

In this optional plan you pay your taxes for Roth 401k and your contribution has to be made with the money you have left.

The advantage of choosing this option is that when you retire, no taxes will be applied to your withdrawals.

This plan is ideal for individuals who think they will be in a higher tax bracket once they retire than they are now.

You can only contribute to Roth IRA if your earnings are below a certain threshold.

That threshold is $135,000 for single filers and $199,000 for married filers in 2018.

401k disadvantages

While it’s advantageous to invest in 401k if your employers offer you the opportunity, there are some restrictions you should have in mind

For example, in most cases you can’t access your employer’s contributions immediately, you must first work for the same employer for a certain number of years.

Your payments on the other hand are free for your employer to use immediately.

Also, there are costly penalties for accessing your funds before retirement.

The volatility of the market can cut a substantial part of your retirement.

If the market crashes, your account that is associated with the enterprise you work for may be affected.

Important to note, you are going to be paying fees, often with no return. A standard management fee is 2% of your total account value.

Besides paying the person that manages your account, you will be paying many more fees.

Distribution rules for 401k plans

Differently from IRA’s distributions that can be made at any time, 401k distributions need for very specific requirements to be met.

The conditions that need to be met for you to be able to withdraw money are:

The employee needs to be retiring, dead, disabled or separating from service with the employer;
The employer needs to be 60 years old;
In case the employer experiences a hardship;
The plan is over;

A “hardship withdrawal” is an emergency withdrawal from a retirement plan. Such withdrawals are subject to certain tax penalties.

Beyond 401k see more about Social Security – Click here.

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