The 401k retirement plan is a trust in which employees are
allowed to contribute money before taxes are assessed. Some employers as part
of their benefits package also provide participants with matching funds to the
employee's 401k account.
Your money is invested in investment options that you choose
from the ones offered through your company's plan. The federal government
established the 401k in 1981 with special tax advantages, to encourage people
to prepare for retirement.
They get their catchy name from the section of the
Internal Revenue Code, which established them.
In 401k retirement plan, few options such as mutual funds,
which are money market funds, bond funds of varying maturities and various
stock funds, are available.
Some companies also allow employees to invest in
company stock. Generally, for an individual who chooses to invest in this way, stock
funds give the best performance.
In the 401k account, the employee may have the option of
selecting particular investment options for the money. In addition to building
retirement funds, contributing to your 401k reduces your taxable income and
helps you keep more of your hard-earned money.
401ks are widely considered as means
of building your pension for retirement and an outstanding financial tool.
You may participate in the 401k plan if as a full-time employee;
your employer offers a retirement plan that qualifies under 401k laws.
Through a 401k, you can authorize your employer to deduct a
certain amount of money from your paycheck before taxes are calculated, and to
invest it in the 401k plan.
How Does 401K Work?
Generally, payments are auto-deducted from your paycheck
into your retirement account. Depending on the specifications made when you
joined the plan, your balance is invested.
If your employer provides matching
funds, this part of your account balance may not be available for some number
of years after which it becomes part of your vested balance.
But with 401k, until the time you withdraw the money, it is not taxed. So if
you've retired, you will likely be in a lower tax bracket, which results in
less money going to the taxman. Also, by means of the power of tax-deferred
compounding interest, your money grows faster.
Since 401k contributions are typically made directly from
your paycheck, saving for retirement is made easy. It is even possible to take
out a loan against your 401k account balance, and the best part is that any interest that you would be
paying on the loan won't go to a bank.
It will be deposited into your account
along with the repaid principal. Be sure that you are prepared to leave the
money in your 401k retirement plan alone, since there is a 10% penalty for early withdrawal and you will be liable for the deferred income
taxes.
For example, if you earn $1,000 each paycheck, and you
contribute, say 5% ($50), you are only taxed on $950. You don't owe income
taxes on the money until you withdraw it from the plan, when you could be in a
lower tax bracket.
Depending upon your employer's status as a small business,
and their ability to fund a 401k, there are several variations of the 401k.
- The SIMPLE
401k
- The traditional
401k
- The Safe
Harbor 401k
All the plans vary as to their contribution limits, the
employers required matching contributions, and the level of administration and IRS
reporting that must be factored into the plan upkeep.
Simple 401k
For small businesses that have a reliable earnings stream,
the SIMPLE 401k is best suited. Their cash flow and earnings level are fairly
steady and reliable, and for providing retirement funding, they want to
establish an easily controlled method.
The disadvantage in operating this type of retirement
account lies in the fact that contributions made on behalf of the employee by
the employer are not optional, and some form of contribution must be made each
year.
Traditional 401k
The traditional 401k is the most often avoided plan by small
to medium sized businesses, simply because of the massive reporting
requirements, and the compliance testing that must be done each year.
The administrative costs for the traditional 401k for a
company of about 10 employees costs around $2000 per year to administer, and
that doesn't include the setup costs or the costs of loan features.
Safe Harbor
401k
The Safe Harbor
401k is a spin-off of the traditional plan, except for the fact that there
aren't all the compliance requirements and testing that must be completed each
year.
For the small business that has a steady revenue stream, and that is able
to make a required contribution each year to the employee fund, the Safe
Harbor plan is best suited.
The Safe Harbor
401k is simple to set up, can be accomplished within 30 days of the New Year,
and is simple to administer. The disadvantage to this plan is the required
contribution rates, and if the business does not have a steady cash or revenue
flow, it is not a recommended plan.
After examining the different plan options available for
small to medium companies, there should be at least one that fits within any
small businesses scope of operations.
Providing retirement funding for small
business family members, as well as all other employees is one of the greatest
benefits a company can offer current and prospective employees.
Company-sponsored 401k plans (named after the section in the
tax code that allows them) are widely used and are very popular. Generally, you
can invest as much as $11,000 of pretax earned income and have it grow tax
deferred. Usually, the money is in a mutual fund through a mutual fund company
or an insurance firm.
Because your money is in a mutual fund that may invest in
stocks, take an active role in finding out the mutual funds in which you're
allowed to invest.
Most plans allow you several types of stock mutual funds.
Use your growing knowledge about stocks to make more informed choices about
your 401(k) plan options.
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