What is 401(k)?
401(k)s are the most popular retirement savings plan. It is an employer sponsored retirement savings plan with special tax benefits. Typically, this plan is a company- sponsored retirement account in which employees can contribute a percentage of their income. Employers often offer to match at least some of these contributions.
Types of 401(k) Plan
There are two basic types of 401(k)s, namely, traditional and Roth, which differ primarily in how they are taxed. Both plans offer tax advantages, either now or in the future.
1. Traditional 401(k) plan: This is an employer sponsored plan that gives employees a choice of investment options. Employee contributions to a 401(k) plan and any earnings from the investments are tax deferred. An individual can pay the taxes on contributions and earnings when the savings are withdrawn.
2. Roth 401(k) plan: This plan is like the traditional plan with one major exception. Contributions by employees are not tax deferred but are made with after-tax dollars. Income gained on the account, from interest, dividends or capital gains, is tax free.
What are the advantages of 401(k) plan?
1 Tax advantages: Contributions to a traditional 401(k) are taken directly out of your paycheck before federal income taxes are deducted. As these contributions are pre -tax, it lowers one’s total taxable income which leads to lesser income tax deductions.
2. You are in Control: One can contribute as much or as little to his/her account but still have the flexibility to change one’s contribution levels at any time (subject to plan limits).
3. Time is on your side: The earlier one starts investing, the more time one has, to grow one’s money. One of the biggest advantages of investing in a 401(k) plan is compound interest. In simple terms, this is a type of interest when one earns interest on interest. Compounding has a big impact on long-term investment and should be considered a powerful ally when it comes to saving for retirement.
4. Money stays with you : Even if you change jobs, the money you have contributed to your 401(k) plan and its earnings belong to you and so, even if you have left an employer, but still have an old 401(k) plan with them, one can explore options for either leaving it in the plan or moving it else somewhere.
5. Easy Payroll deductions: With 401(k), one can make automatic contributions directly from your paycheck. It makes saving a simple and effortless process.
