A 401k plan allows you to set aside a certain amount or percentage of tax-deferred income each year. Your employer funds your 401k plan with matching dollar-for-dollar contributions, and total funds mature tax-free until withdrawn at a certain specified age, typically 59 1/2.
The contributions of your employer to your 401k are usually conditional on a vesting requirement. This means that you must work at least 1,000 hours per year to be 100% vested after seven years or less and gain access to employer contributions to your 401k. However, vesting is subject to exceptions by Federal Law.
How much should you invest in your 401k Plan?
It is to your best interest to make maximum contributions to your 401k plan in order to match your employer’s contributions.
To illustrate how a 401k plan works, assume that you invest 3% of $60,000 annual salary in your 401k plan. That makes $1,800 that should be matched by employer contributions. You are allowed to invest as much more than $1,800 without any limit, but the contribution limit for your employer is 6% of your pre-tax gross salary. This means that your employer cannot contribute more than $3,600. So, if you can match this amount of money by contributing a small amount to your 401k each month, you set a good foundation for your retirement years.
According to the IRS, the maximum employee contribution for 2010 is $16,500 in pre-tax dollars. For employees who are older than 50, the IRS allows another $5,500 as a Catch-Up Contribution Limit on a pre-tax basis. Also, the total amount — including both employee contributions and employer contributions — cannot exceed 100 percent of the salary or $49,000 for 2010 and 2011.
Tax benefits of 401k plans
Traditional 401k plans allow you to make pre-tax contributions of income and invest these contributions in a tax-deferred account. Because your contributions are pre-tax payroll deductions, your taxable income is reduced.
For instance, if you belong in the 20% tax bracket and you earn $1,500 paycheck, the tax withheld from your paycheck would be $300. By making $150 contribution to your 401k plan (10% of your paycheck), your taxable income will be reduced by $150, to $1,350. Consequently, the tax withheld from your paycheck would be $270 ($1,350 x 20%). So, any additional amount you can contribute to your 401k up to your plan’s limits lowers your taxable income.
401k plan investment options
401k plans offer a wide variety of investment options that allow you to reach safe retirement. Accumulating sufficient resources and consistently achieving high returns in volatile markets is quite complex. However, with a 401k plan you have the ability to choose more aggressive investments when you start and less risky investments as you approach retirement.
The most popular 401(k) plan investments options are:
a) Mutual Funds
Mutual funds invest in a pool of funds that consist of stocks, bonds, and other securities. Each investor owns shares of the common fund, which represent a portion of the total holdings of the fund. Mutual funds are lower risk and safer than stocks.
Typical 401k mutual funds include either money market funds that provide low, but safe returns by investing in treasury bills and certificates of deposit, or balanced funds that leverage the investment risk with the safety of investing in fixed securities.
b) Stock Funds
Stock funds, or equity funds, invest in small-cap (<$500 million), mid-cap ($500 million to $5 billion) and large-cap (> 5 billion) stocks.
Typical 401k equity funds include: 1) index funds that invest in stocks that follow market indexes at a relatively low risk, 2) income and growth funds that invest in companies with a fast growth potential at a moderate risk, 3) growth funds that invest in moderately profitable companies with high growth potential 4) aggressive growth funds that invest in highly profitable companies at a high risk and 5) international funds that invest in foreign companies with high growth potential with political, economical and exchange rate risk.
Conclusively, a 401k plan can be a really effective tool for setting up a safe retirement. By contributing tax-deferred money and paying taxes on contributions when you withdraw the money, you can save money for your retirement quickly, effectively, but above all, safely.
Does the 401(k) max contribution limit include the employer match?