Making The Best Use Of Your 401(K) Plan

A 401(k) plan is a tax-advantaged and defined-contribution retirement account offered to employees by their employers. The 401(k) plan has a section in the United States Internal Revenue Code. Employees make contributions to their 401(k) accounts via an automatic payroll withholding, and then the employers can match some or all of the contributions made by the employees.

Two types of 401(k) accounts exist. These are traditional 401(k)s and Roth 401(k)s. The two types of 401(k) accounts are similar in many aspects, however, differ in the way they are taxed. Employees can operate either or both types of account.

 The investment earnings in a traditional 401(k) plan are usually not taxed until the employee withdraws that money, often after retirement. Withdrawals could be tax-free in a Roth 401(k) plan.

In a 401(k) plan also known as a defined contribution plan, the employee and employer usually make contributions to the account, up to the dollar limits set by the Internal Revenue Service. Recently, 401(k) plans have become very familiar and useful, while traditional pensions have become increasingly rare, as employers have shifted the responsibility and risk of saving for retirement to their employees. Traditional pensions are referred to as defined benefits plans and the employer is responsible for providing a specific amount of money to the employee upon retirement.

Employees are solely responsible for choosing the specific investments within their 401(k) accounts, from the selection their employer offers. The offerings include an assortment of stock, bonds, mutual funds and target-date funds that hold a mixture of stocks and bonds appropriate in terms of risk for when that person expects to retire. They may also include guaranteed investment contract issued by insurance companies or stocks owned by the employer.

The highest amount that can be contributed by an employee or employer to a 401(k) plan is often adjusted routinely to account for inflation. According to the Internal Revenue Service: As of 2019, the basic limits on employee contributions are $19,000 per year for workers under age 50 and $25,000 for those 50 and up (including the $6,000 catch-up contribution). If the employer also contributes (or if the employee elects to make additional, non-deductible 'after tax contributions' to their traditional 401(k) account), the total employee/employer contribution for workers under 50 is capped at $56,000, or 100% of employee compensation, whichever is lower. For those 50 and over, the limit is $62,000. The report predicts that in 2020, all those figures go up. Basic contributions rise to $19,500 and the catch-up to $6,500. The cap, including employer contributions, becomes $57,000—$63,500 for those 50 and older.

Employers who match their employee contributions use different formulas to calculate that match. Financial advisors often recommend that employees try to contribute at least enough money to their 401(k) plans each to get the full employer match.

Employees can organize their account in such a way that if an employer offers both choices, they can split their contributions, putting some money into a traditional 401(k) and some into a Roth 401(k). Though, the total contribution to the two types of accounts cannot exceed the limit for one account (such as $19,500 in 2020). Employer contributions can only go into a traditional 401(k) account, where they will be subject to tax upon withdrawal.