Many employers offer a retirement savings account as a benefit for their employees. There are several versions but the most common is called a 401-K, after the section of the IRS code where it is described. This is a savings account created by an employer and managed on their behalf by the employer.
In return for certain restrictions, the money an employee puts into a 401-K account is pre-tax. That means that the money saved is taken off an employee’s gross earnings before any income tax is calculated. The income tax owed on that sum is deferred until the date it is withdrawn by the employee, usually after retirement when he or she should be subject to a lower tax rate.
Employers design their 401-K plans in a variety of ways. A few restrict investments to company stocks and bonds. Others select a large variety of investment options for their employees to pick from. Usual choices may include the different types of mutual funds, stock or bond, growth, income and so on. Some employers provide other choices such as real estate investment trusts or even gold.
An employer is not required to contribute to a 401-K. The plan, when created, spells out the employer’s options for contributions. If the plan provides for an employer contribution, it is usually based on matching a percentage of the employee’s contribution but not exceeding it.
The amount of money that an employee can contribute to a 401-K is restricted, and increases slightly nearly every year. There is a catch-up provision for employees over 55 that allows them to contribute more, within limits, on the assumption that they need to make up for not saving in their younger years.
The tax deferred status of the contributions is based on strict regulations on the employee’s ability to withdraw money from the 401-K plan. There are a small set of circumstances that allow withdrawal without penalty. Other than those circumstances, not only is the money taken out of the plan taxable in the year of withdrawal, there is a 15% penalty assessed for taking it out. Depending on the employee’s tax bracket and any state income tax, taxes and the penalty could amount to 40% or more of the amount removed from the plan.
After retirement, 401-K regulations mandate when withdrawals must begin and how they are calculated. These withdrawals are now income to the retired employee. Any investment gains or losses, along with investment income and employer contributions, become a tax issue. Most, but not all, are treated as ordinary income. Some less common forms of 401-K investment could require accounting for capital gains or losses.
For an employee, a 401K plan has many benefits. Contributing to such a plan lowers current taxable income and reduces withholding. A contribution of $100 will lower a paycheck about $85. With most plans, an employee’s investment choices allow a range of risk, from none to high, and a corresponding gain or loss. Add in employer contributions, and an employee’s 401-K balance at retirement could be significant, perhaps in the millions of dollars. A 401-K plan is one employer benefit worth consideration.