In the United States, a 401(k) plan is a retirement savings plan that allows employees and employers to contribute a portion of their wages to individual accounts. It is named after a section of the U.S. Internal Revenue Code. Employee funding comes directly off their paycheck and may be matched by the employer. There are two main types corresponding to the same distinction in an Individual Retirement Account (IRA); variously referred to as traditional vs. Roth, or tax-deferred vs. tax exempt, or EET vs. TEE. For both types profits in the account are never taxed. For tax exempt accounts contributions and withdrawals have no impact on income tax.
What are the benefits of a 401k?
401 tax benefits are hard to dispute, as they can offer workers a lot of financial security, including:
Shelter from creditors
401k employer match
Do you like free money? Good, now that we've got that out of the way, a company-matched 401k is basically that. Many employers offer to match employee contributions, either dollar for dollar or 50 cents to the dollar, up to a set limit. So, for example, say you make $100,000 a year (#baller) and your employer offers a 401k matching of 50% up to the first 6% you elect to contribute. If you contribute 6% of your annual earnings ($6,000), your employer would contribute an additional 50% of that amount. So, 3,000 free dollars.
It's up to your employer to decide what percentage they will match, but many companies do offer a dollar-for-dollar match.
401k tax breaks
The tax benefits of 401ks are like the triple-crown of finances. First, contributions are pre-tax. You don’t pay taxes on the money until you withdraw it when you retire. (At the earliest, this is age 59.5.)
Second, your 401k contributions are not counted as income, which could put you in a lower tax bracket. The result: your tax bill will be smaller for your having squirreled away money for your later years.
Third, your savings grow tax-deferred. In a regular investment account, your net gains and dividends would be taxed. But in a 401k plan, your money grows tax-free as long as it stays in the plan. This allows your earnings to compound -- which is just a fancy way of sayings, your earnings will earn earnings.
401k shelter from creditors
If your finances take a turn for the worst, you won't have to worry about creditors coming for your 401k. Your qualified retirement plan is protected by the Employee Retirement Income Security Act of 1974 (ERISA) from claims by judgment creditors.
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