By miguel cane
A 401(k) plan is a tax-qualified deferred compensation plan. You can require your employer to pay a portion of your salary in cash to a specific plan before taxes are paid if the plan entitles you to do so.
The 401(k) Plan and its features
Unlike an IRA, which you open yourself, an employer opens a 401k for you. If you are applying for a job in the United States, find out under what conditions the employer opens this plan to you. This is quite a significant advantage.
- The employer simply opens this plan for you, allowing you to reduce taxable income and invest your funds. In 2016, the maximum amount that could be deposited into a 401k account was $18,000.
- The employer makes a match. This means that if he deducts, say, 5% of his salary in his 401k, the employer adds the same amount to his account. In general, the contract specifies up to what % the employer will make the compensation.
- Regardless of your investment, the employer credits a certain % to your 401k account. Tax authorities also regulate the maximum size of an employer’s investment.
- You can invest money in your account in particular securities, or rather, in certainly formed portfolios of securities (you determine the level of risk and return). Funds can be withdrawn from your account until you reach age 59.5 (that is, before the 401k retirement age) under certain conditions.
- You resign. In this case, you can simply leave that money and then transfer it to the same plan of another employer (different intermediary companies manage the savings) or take it with you by paying taxes.
- Hardship withdrawals. If you have any health problems, you can use this money. In addition, this money can be used to pay for a home loan or for tuition. In almost all cases of hardship withdrawals, you will pay taxes and a penalty of 10% of the amount.
It is also possible to obtain a loan through the 401k plan (usually for 5 years), although this is not recommended. The rate will be below the market and, at the same time, you will pay this % to yourself. But, keep in mind that you will pay 2 times taxes in this case. You’ll repay the loan (return to your 401k account) in after-tax cash and pay taxes again after you reach age 59.5.
The benefits of the 401(k) plan
First, contributions to the 401k plan are tax-free, which means you’ll pay less income tax at the end of the year. This can mean thousands of dollars in savings for families where both husband and wife work.
Second, your 401k equity grows significantly faster in a tax-deferred retirement account compared to a fully taxed brokerage account. In a 401k, all of your income goes into your balance and your taxes are deferred until you withdraw your money at retirement.
Why is the 401k plan convenient and designed in your favor? You don’t need to write a check, call your broker, or do anything else to contribute. You really don’t need to do anything because your employer will automatically deduct your contribution directly from your paycheck. After a while, you forget that an amount is deducted from your paycheck. At the same time, your 401k contributions continue and your retirement capital grows.
No minimum initial investment limits. Another amazing feature of 401k plans is that there is no minimum amount to start. You can start with a minimum of money! In contrast, if you’re looking to contribute to retirement by opening a self-managed Vanguard IRA, you’re better off with at least $3,000 in starting capital for most funds. With a 401k plan, you don’t have to worry about minimums!
You can also start planning for your retirement and take advantage of all the benefits the 401k plan offers, such as the convenience of automatic investments, employer premium matching, tax deferral, maximum contribution limits, cost averaging, and no minimum initial investment.
