What is 401(k) Plan

A 401(k) Plan is a retirement plan designed by the US government and sponsored by the employer for an employee. The name of the plan is coined after a section of the US Internal Revenue Code. The plan aims at providing retired workers in the public sector some tax advantage by allowing the employer to create a retirement contribution account on behalf of the workers.  Workers are allowed to make contributions to the account using the automatic payroll withholding, the employer then matches all or some of the contributions made by the employee. The 401(k) plan account is not taxed until the employee wants to withdraw his or her money, usually after retirement.

There are two basic types of 401(k) Plan

  • Roth 401(k) Plan

  • Traditional 401(k) plan

The major difference between the two is how they are taxed. In Roth 401(k) plan, no tax payment is required whenever a payment is to be made. This is because, when an employer wants to withdraw, he or she uses a post-tax income.

In the traditional 401(k) plan, the contributions made by an employee reduces his or her income taxes for the number of years the contribution is made, however, withdrawals are taxed.

How Contributions Are Made Into A 401(K) Plan

The method of contribution to a 401(k) plan is defined. This implies the Internal Revenue Service sets the maximum amount of money that can be saved into the account.

Both the employer and the employee are allowed to make contributions up to the defined amount stated by the IRS. This is why a 401(k) plan is also referred to as a defined-contribution plan. The method of contribution is what differentiates a 401(k) plan from a traditional pension.

Traditional pension is a defined-benefits plan. The employer defines the maximum amount in a traditional pension, while the IRS defines the maximum amount in the 401(k) plan.

In a 401(k) plan, the employer makes a random selection of investment accounts, then the employee chooses from the selected accounts

An employee's maximum contribution to the account is usually adjusted in line with inflation and deflation. For instance, as of 2019, the standard limit an employee can contribute include,

  • Employees at the age of 50 and above $25,000 per year.

  • Employees at the age of 49 and below $19,000 per year

  • The maximum amount an employee from age 50 and above can contribute is $65,000 while the age below 50 is $56,000.

However, in 2020, the maximum contribution increase with an extra $500.

Employees are allowed to split their account into the two types of 401(k) plan, but their contributions to both accounts cannot exceed the stipulated amount.

How To Withdraw From A 401(K) Plan Account.

According to the IRS regulations, to withdraw from your 401(k) account you must be of age 59½ and above or completely disabled. Aside from these two conditions, any other withdrawal would be subjected to the 10% penalty for early distribution.

Employers within age 70½ must withdraw a specific amount from their 401(k) plan. This would be done using the IRS tables on life expectancy.

Special Conditions: Job Changing

There are four options for an employer who leaves a company where a 401(k) plan has already been set for him or her. The conditions include:

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