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I sometimes am posed the question, “How does a 401k work, anyway?” Well the answer depends on who is asking the question. Usually the question comes from the employee, an individual, so let’s learn about a 401k from the employee’s perspective.
The Contribution
In a 401k, employees have an opportunity to defer the action of receiving a portion of their earned income. This portion instead is diverted into a participant-owned 401k account. This action effectively reduces the employee’s taxable income by the amount of the deposit, as far as the IRS is concerned.
The annual maximum contribution to a 401k plan is $16,500 for the year 2011. For 2012, that number has been increased to $17,000. Of course, any amount up to this amount is allowed as an annual deferral amount to you. And the amount of deferral made this year may not be the same as next year.
401k Investments
Once the funds are diverted into the 401k account, the individual has the option of now investing the funds that have been put into the account.
Usually the options available to participants consist of company stock and mutual funds. The employer generally has full authority on what specific options are available to the employee. Be cautious with 401k investment advice.
The Match
Often, the employer will entice the employee to participate in the 401k plan in order for the more highly compensated individuals within the company to be eligible to participate as well. To accomplish this, employers may offer what is called a 401k match. This match makes employer contributions to the employee’s account, usually based on the level of contributions by the employee.
Recently, many company 401k matches have been suspended due to economic pressures. Whether and when these matches return to pre-recession standards is anybody’s guess. One thing is for sure, the decision of whether or not to contribute to a 401k plan is much easier when a match is available to employees. If a match is being offered by the employer, employees should generally take the free money if possible.
401k Tax Consequences
As mentioned above, the 401k deferral, or contribution amount, reduces taxable income. Also, any growth on the funds that have been previously deposited into the account are excluded from taxation in the year they occur. This is called "tax deferral."
All taxes will be due when funds are withdrawn from the 401k account, generally at retirement. The tax rate used will be the ordinary income tax rate of the individual account holder.
401k Early Withdrawals
Generally, a 401k early withdrawal is the action of taking out funds that reside in the account before the participant reaches the age of 59½. With a few exceptions, 401k early withdrawals are penalized at a rate of 10%. This penalty is in addition to the ordinary income tax that will be applied to the withdrawal.
Generally, a 1099 tax form will be issued to the account holder at the beginning of the year following the withdrawal. The form will detail the gross amount withdrawn and any tax withholdings submitted to the IRS.
401k Summary
These retirement accounts can be a real boon for employees who would like to contribute to their retirement. With tax-reducing contributions, tax deferral on growth, and a possible employer match these retirement plans can help savers plan for their future and reduce taxable income.
I hope this page clarifies the 401k. If it does, congratulations! Now you know what to say if someone asks you the question, “How does a 401k work?”
401kFundAdvice will make portfolio recommendations, based upon your 401k investment choices, four times per year.