The 401(k) plan is a retirement account. It is company-sponsored, and employees can contribute their income to the account. Furthermore, their employers match the contribution. The two types of 401(k) accounts are traditional plans and Roth plans; they differ in how they are taxed. 

How does the 401(k) plan work? Is it worth it?

Let’s find out.

What Is A 401(k) Plan?

A 401(k) plan is a retirement savings plan American employers offer to their employees. The savings plan derives its name after a section of the U.S. Internal Revenue Code, and it has tax advantages for the saver. 

Employees that sign up for the 401(k) program agree to pay a certain percentage of their paycheck directly into an investment account. The employer may choose to match part or all of the contribution. Furthermore, the employee can choose between several investment options, including mutual funds. 

How Do 401(k) Plans Work?

The United States’ congress designed the 401(k) plan to encourage Americans to save for retirement. A major benefit they offer is tax savings. These tax savings have two options including;

Traditional 401(k)

The traditional 401(k) plan deducts contributions from employees’ gross income – the money is deducted from an employee’s payroll before income taxes. Therefore, the taxable income is reduced by the contributions for the year. Also, the contributions are reported as tax deductions for that year. In retirement, when an employee withdraws the money, taxes are due on the earnings.

Roth 401(k)

The Roth 401(k) is slightly different from the traditional plan. In Roth 401(k), contributions are deducted after income taxes must have been deducted. Therefore, there is no tax deduction for that contribution year. When an employee withdraws their investment savings in retirement, no additional taxes will be due. 

It is important to note that not all employers offer the Roth 401(k) plan. In cases where an employer offers the plan, an employee can choose between a Roth and a traditional plan. The employee may also choose both up to the annual limits of their tax-deductible contributions.

Is Having A 401(k) Plan Worth It?

401(k) plans help employees save for retirement. It is easy to save because the contributions are automatically deducted. Furthermore, 401(k) plans have tax advantages, and some employers match their employee contributions. Generally, employees gain more from the 401(k) plan, especially when their employers match the contribution.

How Much Salary Do I Need To Contribute To A 401(k) Plan?

Annually, the amount employees can contribute to their 401(k) plan has adjustments because of inflation. In 2021, employees have a limit of $19,500 for people aged 50 and $26,000 for people above 50. Employees that benefit from an employer matching their contributions have a contribution cap. The contribution is capped at 100% of the employees’ compensation for the year or a capped value of $58,000 in 2021.

What Happens When An Employee Leaves Their Job?

There are four options for employees who leave a company that provides a 401(k) plan. The options include:

• Withdrawing the money.
• Rolling the 401(k) into an IRA.
• Leaving the 401(k) with the old employer.
• Moving the 401(k) to the new employer.

Conclusion

A 401(k) plan helps employees save for retirement from their paychecks into a long-term investment account. An employer can decide to contribute as well. The traditional 401(k) plan gives employees immediate tax advantages, while the Roth 401(k) plan gives employees tax advantages after retiring. Whichever plan you choose, your money won’t be taxed till you withdraw it in traditional plans, and in the Roth plan, there are no taxes due when you withdraw your money.