A 401(k) plan is a tax-advantaged retirement savings plan offered by employers to their employees. It allows employees to contribute a portion of their pre-tax income towards their retirement savings, which can grow tax-free until withdrawn in retirement. Employers may also choose to match a portion of their employees' contributions, thus incentivizing them to save more for retirement. The employee who signs up for a 401(k) agrees to have a percentage of each paycheck paid directly into an investment account. The employer may match part or all of that contribution. The employee gets to choose from among a number of investment options, usually mutual funds.

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One major advantage of a 401(k) plan is its flexibility, as employees can adjust their contribution amounts and investment choices over time. Additionally, 401(k) plans offer significant tax benefits for both employees and employers. For employees, contributions reduce taxable income and earnings grow tax-free until withdrawal. For employers, offering a 401(k) plan can be a valuable tool for attracting and retaining top talent and offer tax advantages for employer contributions.

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To participate in a 401(k) plan, employees typically need to enroll during an open enrollment period or after becoming eligible through their employer. Contribution limits are set by the IRS and usually increase each year, with the current limit at $22,500 per year for those under age 50. Those age 50 and older may make additional "catch-up" contributions of up to $7,500 per year. Other factors that may affect contribution limits include employer matching contributions, plan type, and income level.

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Pre-Tax Deferral:

A traditional 401(k) plan involves deducting employee contributions from their gross income, which means that the money is taken out of their paycheck before taxes are withheld. This results in a reduction of taxable income for the year, and the total contribution amount can be reported as a tax deduction for that year. There are no taxes due on either the contributed amount or the investment earnings until the money is withdrawn, usually during retirement.

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Roth Deferral:

On the other hand, a Roth 401(k) salary deferrals involve contributions being deducted from an employee's after-tax income, meaning that the funds are taken out of their pay after taxes have been withheld. As a result, there is no tax deduction for the contribution in the year it is made. However, when the money is withdrawn during retirement, no additional taxes are required to be paid on either the contribution or the investment earnings.

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401(k) plans offer significant tax benefits for both individuals and companies. For employees, contributions can reduce taxable income, thus lowering the amount of income tax owed. For employers, contributions may be tax-deductible as a business expense. To maximize tax benefits, individuals should aim to contribute the maximum allowed amount each year and consider taking advantage of catch-up contributions if eligible.

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Withdrawals from a 401(k) plan are typically only allowed after reaching age 59 1/2, though some plans may allow for earlier withdrawals under certain circumstances, such as financial hardship or disability. Withdrawing funds early may result in penalties and taxes, and can significantly reduce the total savings available in retirement.

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Contribution limits for 401(k) plans are set by the IRS and typically increase each year. The current limit is $22,500 per year for those under age 50, with an additional catch-up contribution of up to $7,500 per year for those age 50 and older. If your income changes, you may need to adjust your contributions accordingly to avoid exceeding contribution limits. Your employer may also periodically offer opportunities to adjust your contribution rate, such as during open enrollment periods.

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