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How Does a 401k Plan Work?

How Does a 401k Plan Work? PhotoOne of the most common deductions seen on a paycheck goes to 401(k) plan. A 401(k) plan is a type of retirement savings account available to U.S. citizens.

How does this retirement plan work? How different is it from other retirement plans? What are the advantages and disadvantages of this account? Read through to know more about 401(k) plans.

Basics of a 401(k)

It’s the most common kind of defined contribution retirement plan. It means that fixed contributions are paid into an individual account by employers and employees alike.  A 401(k) plan is normally offered to you through your employer.

Money invested in this type of plan is usually invested in mutual funds and money market accounts. This is how the invested funds grow and gain interest.

Upon retirement, members could enjoy the retirement benefits indicated in the terms.

Difference from other plans

Like in IRAs, 401(k) plans give its members a certain degree of responsibility in selecting the types of investments toward which the funds in the retirement plan are allocated. Money invested is handled by a third-party financial manager who invests it in mutual funds, bonds, or money market accounts. It depends on you where you’ll put your contributions.

The greatest difference with other retirement plans would be the way taxes are applied in the contributions. In a traditional 401(k), contributions are “tax-deferred”, meaning they’re deducted from paychecks before taxes and then taxed when a withdrawal is made from the account.

Contributions

You always have the option to either proceed or decline with the 401(k) plan your company offers. When you choose to proceed, a portion of your pre-tax earnings will go to the company’s 401(k) plan. Depending on the employer’s program a portion of the employee’s contribution may be matched by the employer.

The IRS sets a limit on how much an employee can contribute in his/her 401(k) retirement plan. As of 2012, the limit is $17,000.

Rollovers

If you’re planning to change jobs or you’re nearing retirement, you might need to confer with your employer on what you’ll do with your current 401(k) plan.

There are several options for you to choose from. Some employers might allow you to retain your funds in the company. Your new employer might even allow you to roll your funds from your previous 401(k) plan into the 401(k) they offer.

If you’re retiring, you also have the option to roll the funds you accumulated into an IRA or just proceed with a lump sum withdrawal. Choosing the latter though could cost you a 10% early withdrawal penalty if you haven’t reached age 59 and a half at the time of withdrawal.

Benefits

One of the several advantages of a 401(k) plan against its counterparts is its high contribution limits – which is up to $17,000 per year, as of 2012. Contributions made can also be deducted from the net income of account holders.

Taxes are also deferred in a 401(k) plan, meaning taxes aren’t applied on the contribution. Taxes will only apply upon withdrawal of funds.

If you’re lucky enough, your employer might even match your contributions up to 6% of your salary.

Drawbacks

Delaying taxes on the contributions could also have negative effects on your savings. When you withdraw money from your plan, it is taxed as additional income. Income tax by the time you withdraw has the possibility of being higher than the rates today.

There are also penalties for early withdrawal. Taxes could reach up to 20% of the value plus a 10% penalty if you withdraw before age 59 1/2.