How Does a 401(k) Plan Work?
So, what is a 401(k)? Here's what you need to know, including how contributions and employer matching work.
What Is a 401(k) Plan?
A 401(k) plan is a retirement savings and investment account offered by employers that allows employees to contribute pre-tax income. The term comes from the section of the Internal Revenue Code that established and governs this type of retirement plan.
Contributions are convenient since the desired amount is often just deducted from each paycheck. Many employers also choose to contribute to their employees’ 401(k) accounts. Keep in mind, though, that the IRS limits how much employers and employees can contribute in a given year and adjusts that limit for inflation each year.
To be clear, 401(k) funds are not tax-free. Instead, they are tax-deferred, which means employees benefit upfront by lowering their taxable income but will eventually have to pay federal and state income tax on any funds they withdraw from their 401(k) account.
Individuals can also face a 10% penalty on top of taxes if they withdraw funds too early. To avoid the “early-distribution” penalty, working employees must be at least 59.5 years old, and retirees must be at least 55. This ensures that employees only use these tax-advantaged accounts for retirement. However, some employers allow individuals to avoid the “early-distribution” penalty under limited circumstances of financial hardship, such as paying for medical or funeral costs.
While some larger organizations may enroll new hires in a 401(k) automatically, many small to midsize employers require a waiting period. For example, an employee may need to stay with the employer a full year before the employer will contribute to their retirement account.
So, how do employers contribute to employees’ 401(k) plans?
How Does 401(k) Employer Matching Work?
Employers are not required to contribute to employee 401(k)s, but those that do contribute have several options for how to do so.
Many employers contribute a fixed percentage of each employee’s salary while others will match an employee’s contribution up to a certain percentage. For example, an employer may match 3% of an employee’s salary, or they may match 50 cents on the dollar for employee contributions up to 6%.
Since there’s no requirement to contribute to employee 401(k)s anyway, employers have a lot of flexibility on how to formulate their contributions.
An employer’s matching contribution is essentially more money for the employee in the long run. That’s why financial advisors often encourage their clients to contribute at least enough to take full advantage of their employer’s match if the individual is financially able. Of course, each employee’s situation is different, and they should consult a financial advisor before determining how much to contribute to their particular plan.
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