When it comes to retirement planning, a 401(k) plan is crucial financial account for millions of American workers. This retirement savings plan is offered by many US employers and comes with several tax benefits. It is named after Section 401(k) of the US Internal Revenue Code.

What is a 401(k) Plan?

Employers sponsor a 401(k) plan as a benefit to their employees. Employees who participate in a 401(k) plan agree to have a certain percentage of each paycheck contributed directly to an investment account. Employers may make matching contributions or provide non-elective contributions (commonly known as “profit sharing” contributions).Employees can choose from many investment options, typically mutual funds.

Key takeaways:

￭A401(k) plan is a retirement savings plan offered by many US employers.

￭Employees agree to have a certain percentage of each paycheck contributed to a 401(k)account, which may be matched by the employer.

￭There are two basic types of employee contribution types in 401(k) plans: traditional and Roth, with the main difference being how they are taxed.

￭Employees are able to choose from a menu of investment options available in their 401(k) plan, including stock and bond mutual funds, target-date funds, and guaranteed investment contracts (GICs), among others.

￭A401(k) plan is a defined contribution plan, where employees and employers can contribute up to annual dollar limits set by the US Internal Revenue Service(IRS).

The maximum employee contribution amount is set annually by the IRS (currently $22,500 for 2023), and may be supplemented by employer contributions or additional non-tax-deductible contributions such as Roth 401(k) contributions. Employees 50 years of age and older can also contribute an additional $7,500 in “catch up” contributions.

Traditional 401(k)

A traditional 401(k) allows employees to deduct contributions from their pre-tax income, thus reducing their taxable income. This means that both the amount contributed, and the investment earnings, will be subject to taxes upon withdrawal at retirement.

Key takeaways:

￭Employees can receive tax breaks on their pre-tax income by contributing to a 401(k) account.

￭Contributions and investment earnings are taxed upon withdrawal as ordinary income.

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Roth 401(k)

In contrast, Roth 401(k) salary deferral contributions are funded with after-tax income and doesn't offer the same tax break of reducing taxable income. However, contributions and investment earnings can be withdrawn tax-free at retirement.

Key takeaways:

￭A Roth 401(k) is funded with after-tax income and doesn't reduce taxable income.

￭Contributions and investment earnings can be withdrawn tax-free at retirement.

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It's worth noting that while Roth 401(k)contributions are made with already-taxed income, taking withdrawals before age59 1/2 may trigger tax consequences. Therefore, it's recommended to consult an accountant or qualified financial advisor before taking withdrawals from either traditional or Roth 401(k) accounts.

A 401(k) plan can provide American employees with a powerful financial tool as a part of their retirement planning. This type of plan offers flexible retirement savings solutions for employees and usually allows them to choose from a wide array of investment options that can be selected for investment based on their individual needs.

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For employers, a 401(k) plan offers a great employee retention tool as well as provides certain tax advantages for any employer contributions made to the plan.