A 401(k) plan is a type of employer-sponsored retirement savings plan in the United States. It allows employees to save and invest a portion of their paychecks before taxes are taken out. Taxes aren’t paid until the money is withdrawn from the account.
Here are the key features of a 401(k) plan:
- Pre-Tax Contributions: The money that you contribute to a 401(k) plan generally comes out of your paycheck before taxes are deducted. This reduces your taxable income for the year, which in turn, reduces your overall tax bill.
- Employer Match: Many employers will match a portion of their employees’ 401(k) contributions, up to a certain percentage of their salary. This is essentially free money and can significantly boost the growth of your retirement savings.
- Tax-Deferred Growth: The money in your 401(k) grows tax-deferred, meaning you don’t pay taxes on any investment earnings until you withdraw the money in retirement.
- Penalties for Early Withdrawal: If you withdraw money from your 401(k) before age 59.5, you’ll typically have to pay a 10% early withdrawal penalty, in addition to regular income taxes. However, there are some exceptions to this rule.
- Required Minimum Distributions (RMDs): Once you reach age 72, you must start taking required minimum distributions from your 401(k), which are then taxed as ordinary income.
There are two main types of 401(k) plans: traditional 401(k) and Roth 401(k). In a traditional 401(k), contributions are made pre-tax, and withdrawals in retirement are taxed. In a Roth 401(k), contributions are made after tax, but withdrawals in retirement are tax-free. The choice between the two often depends on whether you think your tax rate will be higher or lower in retirement than it is now.