401K Contributions and Your Future Retirement

Posted by freetaxadvisor

December 28, 2008

What is 401K?

Don’t let the number 401K confused you with the plan, this plan is fairly easy to understand and I will try to provide you the best summary that you can find to understand it in a real layman term.

A 401(k) is a retirement plan that was enacted by US government to help US employees save for retirement. This plan is offered by some employers in the United States but not all. The plan received the name from the section 401 of Internal Revenue (IRS) Code it was named after.

401(K) plan is a tax-deferred (contribution is before tax) retirement savings plans for employees. The employer sets up this plan according to federal guidelines and each company has its own 401(K) plan. Amount contributed is defined by the company but bounded by IRS guidelines.

Tax Benefits

One of the top benefits of a 401(k) plan is that contributions are made on a pre-tax basis. As an employee, you are allowed to make pre-tax contributions weekly, bi-weekly or monthly directly from your pay check. Since these contributions are done on a pre-tax basis, you do not pay current income tax on the money that is contributed into the plan and tax is deferred until retirement. (Tax is not due on this money until you retire, that puts time on your side, you keep the money, and money grows tax free). You are only taxed on the money you withdraw from the plan at retirement as ordinary income.

The Employer Match

Some companies offer an additional benefit to 401K to attract good employees by providing a company match contribution. That means your employer contributes additional money into your own plan that matches a portion of your contributions. Some employers match dollar-for-dollar up to a certain percentage of pay (Example $ to $ match up to 3%) while others matches a specified percentage (Example 50Cents on a $ up to 3%) of your contribution.

Another thing to remember is most of the companies will have a vesting schedule in place that requires you to stay at the company for a certain length of time before you can collect the matched contribution. The vesting period could be a gradual scale or a one-time length of service requirement. (Example, 25% vested for each year until four years of service then after 100%, means after you are at the company for four year, 100% of company contribution is yours)

Retirement