401(k): All you need to know about the retirement plan

When we talk about the employer-sponsored retirement account, only the 401(k) pension account comes to our mind. Several reasons are working beyond the popularity of 401(k).

We should have a look at all about 401(k) in detail

What is a 401(k) retirement plan?

The 401(k) is an employer-sponsored retirement account. The 401(k) allows an employee to contribute a percentage of his/her ‘pre-tax salary’ to the employer-sponsored retirement account. The money saved in the retirement account is used in stock market investment, mutual fund investment, and bonds.

How does the 401(k) retirement plan work?

The employers offer the 401(k) plan to ensure each employee has its dedicated retirement plan. The employee has the independence to choose what percentage of his/her monthly salary would go to the 401(k) investment plan. Apart from this benefit, an employee can choose whether the 401(k) investment would go to mutual fund investment, stock market investment, or it will go to bond investment.

You can get more benefits from the 401(k) investment if your employer agrees to match your contribution in the 401(k).

In this scenario, the recommendation of the financial advisors is to increase your investment as much as you can each year.

Thus you may get two benefits both in the tax sector and as the contribution of your employer.

What are the benefits of opening a 401(k) retirement account?

With the 401(k) retirement account you can be assured of getting financial security.

Take a look at the benefits you can get from the 401(k) account:

  1. 1. Employer contributions facility
  2. 2. Tax facility
  3. 3. 401(k) contribution is protected from the creditors and any garnishment

1. The employer contributions facility

Many employers in the USA offer to match the employee’s contribution. Normally, the employers match dollar to dollar or 50 cents to a dollar. The contributions will be up to a set limit.

For example, let’s say your annual earnings are $100,000. You have decided to contribute 5% of your annual salary to 401(k). It means you are contributing $5,000 annually to your 401(k). If your employer agrees to contribute 50% of your contribution in 401(k), then you will get an additional $2500 contribution in the 401(k) account.

This is the benefit of contributing to the 401(k) account. There is a limit for the employers while contributing to the 401(k) account. The general limit of employer contribution is 100% of employee compensation. In 2020, an employer can contribute a maximum amount of $57,000 and in 2021, the amount will rise to $58,000.

2. The tax facility

Getting tax benefits is the other reason people opt for the 401(k).

  • i. Your contribution will be tax-free. You don’t have to pay anything as tax until you withdraw the money at retirement. You can withdraw the money at 59.5 years which is the earliest to avoid paying a penalty.
  • ii. You have to pay taxes if you make regular investments. Both your net income and dividends will be taxed when you will invest. The advantage of contributing to the 401(k) is as long as you keep the money in the retirement account. It will grow continuously in a tax-free manner until you withdraw the money. The reason is, contributing to the 401(k) is never considered as your earning and the amount will never be taxed.

    So, the 401(k) is better than investment if you consider the tax matter.

3. 401(k) contribution is protected from the creditors and any garnishment

The ERISA Act (Employee Retirement Income Security Act) is going to save your 401(k) contribution from the creditors and any garnishment.

The 401(k) is protected from garnishment. So, no matter how much your financial situation worsens, your retirement-dedicated money will always be safe in the 401(k) account.c

These are the 3 major benefits of contributing to the 401(k) account.

What can be your maximum contribution to the 401(k) account?

In 2020, the IRS (Internal Revenue Service) has allowed the maximum contribution of $19,500. For Americans whose age is above 50, they can contribute an additional amount of $6,500 as allowed by the IRS.

Do I have to face penalties if I make an early withdrawal from my 401(k) account?

The rulebook says if you make an early withdrawal from the 401(k) account before you turn 55 and a half, then you have to pay a penalty of 10% and tax will be levied on your withdrawal fund.

So, better for you will be to wait till you turn 59 and a half so that you can avoid the penalty charges.

What are the similarities and differences between Roth 401(k) and Roth IRA?

Before understanding the difference between Roth 401(k) and Roth IRA, it will be better for you to understand the difference between Roth 401(k) and Traditional 401(k). You should also have some knowledge about the Roth IRA.

As you know, the contribution is taken from Traditional 401(k) based on your pre-tax earnings, whereas the contribution is taken from Roth 401(k) based on your after-tax earnings. The Roth 401(k) was introduced in 2006.

Roth IRA is the Individual Retirement Account in which the retirement withdrawals will be tax-free. The rule says that in 2020, your maximum contribution limit will be $6,000, and if you are above 50, then you can contribute an additional $1000 amount.

contribution limit will be $6,000, and if you are above 50, then you can contribute an additional $1000 amount.

There are some similarities between the Roth IRA and Roth 401(k), and there are some differences also.

1. The similarities between Roth 401(k) and Roth IRA

i. Both the Roth IRA and Roth 401(k) go on the same rule. You can withdraw the money in a tax-free way only after you cross the 59 and a half years of age.

ii. When you will contribute to the Roth IRA and Roth 401(k), they are usually taxed.

These two are similar points between the Roth IRA and Roth 401(k).

2. The differences between Roth 401(k) and Roth IRA

The differences that prevail between the Roth IRA and Roth 401(k) are they have different eligibility criteria and their contribution limit is also different.

i. The 2020 rule says if you want to contribute to Roth 401(k), then you can contribute a maximum of $19,500. If you are above 50, then you can contribute an additional amount of $6,500 per year.
The yearly contribution limit of the Roth IRA is not as high as the Roth 401(k). You can normally contribute $6,000 per year and if you are above 50, then you can contribute an additional amount of $1,500 per year.

ii. The eligibility criteria are also different between the Roth IRA and Roth 401(k).
If you want to open a Roth 401(k) account, then at first, your employer has to offer you this option.
You can open a Roth IRA account independently but there is an earning cap attached to the account.
You have to show that your MAGI (Modified Adjusted Gross Income) is within the $139,000 yearly cap if you are filing it as a single person.
If you are filing jointly as a couple, then you have to show your yearly earning cap is $206,000.

So, there is a difference between the Roth IRA and Roth 401(k) both in eligibility criteria and yearly contributing criteria.

Can you withdraw the money from your 401(k) account to pay off debt?

According to the 401(k) savings experts, this is not the best option to withdraw money from the 401(k) account to pay off debt.

The basic loss that you will face is that you will lose the compound interest rate. This is the basic loss of withdrawing money from the 401(k) account

Apart from it, the cost of borrowing from the 401(k) account is very high. Instead of getting monthly interest from the 401(k) account, you have to pay off the interest, too.

The penalties that you have to pay off against withdrawing money from the 401(k) account is quite high.

So, these are the problems you may face when you think about paying off debt by withdrawing money from the 401(k) account.

The better solution for you will be to take out a personal loan or consolidate your debts to solve your debt problem.

Can you contribute money into the 401(k) account without a job?

In a brief, the 401(k) is an employer-sponsored retirement plan. So, to get the above-mentioned advantages, you need to have an employer who will sponsor your 401(k) retirement plan.

Take a look at the two 401(k) Rules:

1. An unemployed person cannot contribute to the 401(k) retirement account.

2. You are not eligible to contribute to the 401(k) retirement account if your ability does not match the employer’s eligibility criteria. For example, the employer may cite a rule that you need to work a certain period to be eligible for the contribution to the 401(k) account.

You have to follow these two rules before contributing money to the 401(k) account.

Final words,

According to the financial experts, you need to direct 10% to 15% of your annual income towards your savings. You have to calculate what amount of money you need at the time of retirement. Based on your calculation, you can contribute your money to the 401(k) retirement account with the advantage of saving in a tax-free manner.