A 401(k) plan enables employees to defer receiving and paying taxes on a percentage of compensation. The salary reduction amount is deducted from the employee’s paycheck and contributed to a retirement fund, where it accumulates earnings tax-deferred until it is distributed. Tax-deferral is advantageous in that it reduces the employee’s annual tax liability, and pre-tax contributions to retirement accounts grow faster than post-tax contributions due to the effect of compounding.
To encourage employees to participate in a company 401(k), many employers make contributions to employee plans in addition to the employee’s contribution. The employer may make automatic contributions to all employee plans, or match employee contributions to individual plans. Employer contributions are sometimes subject to a vesting schedule, meaning the employee must stay with the employer for a certain period of time to have claim to the employer’s additions. In 2009, employees can contribute up to $16,500 to their 401(k) plan, and individuals over the age of 50 can make an additional “catch-up” contribution of $5,500.
Employees should note that an employer 401(k) is not an investment in and of itself. A 401(k) is only an investment vehicle that grants tax deferral, so employees must invest in stocks, bonds, money market funds, and mutual funds within the 401(k). An average 401(k) has about 20 investment options from which an employee may choose.
Employees should only contribute long-term investment funds to their 401(k). With only a handful of exceptions, funds withdrawn from a 401(k) before the employee reaches age 59.5 will be subject to a 10 percent penalty. Income taxes are deferred until money is withdrawn, at which time the funds will be taxed as ordinary income. Once investors reaches age 70.5, they are required to start taking required minimum distributions (RMDs) from their 401(k)s. This enables the federal government to collect tax revenue from the deferred funds.
After leaving an employer, an employee has several options as to what to do with a 401(k). If desired, the 401(k) can stay intact, and it will continue to grow tax-deferred until distributed. Frequently, an employee’s best option when leaving an employer is to roll the 401(k) into an IRA, which opens up a world of investment options and makes record-keeping simple.
In 2006, Roth 401(k)s became available, although employers are not required to offer these plans. Employees do not receive a tax deduction for contributing to a Roth account, but all the money is tax-free upon withdrawal. If an employee believes he or she will be in a lower tax bracket now than when the funds are withdrawn, a Roth account would be a valuable option.