A 401(k) is a retirement savings plan offered by employers to their employees. It allows employees to contribute a portion of their pre-tax income to a retirement account, which is then invested in various financial instruments such as stocks, bonds, and mutual funds. The contributions and investment earnings in a 401(k) account grow tax-deferred, meaning that taxes are not paid until the funds are withdrawn.
The name “401(k)” comes from the section of the Internal Revenue Code that governs these plans. These plans were introduced in the 1980s as a way for employees to save for their retirement while also reducing their taxable income. The plans quickly became popular, and today, they are the primary retirement savings vehicle for many Americans.
Employers who offer 401(k) plans typically provide employees with a menu of investment options to choose from, such as mutual funds, index funds, and target-date funds. Employees can then decide how much of their salary they want to contribute to the plan, up to the annual contribution limit set by the IRS. For 2023, the contribution limit is $20,500 for those under age 50, and $27,000 for those 50 or older, known as a catch-up contribution.
In addition to the employee contributions, employers may also choose to make matching contributions to the plan on behalf of their employees. For example, an employer may offer to match 50% of an employee’s contributions, up to a certain percentage of their salary. Matching contributions can help employees save more for retirement, and can also be a valuable employee benefit.
One advantage of a 401(k) plan is that contributions are made on a pre-tax basis. This means that contributions are deducted from an employee’s paycheck before taxes are withheld, reducing their taxable income. Over time, this can add up to significant tax savings. In addition, the investment earnings in a 401(k) plan grow tax-deferred, which means that taxes are not paid on the earnings until they are withdrawn. This can help employees accumulate more savings over time, as their money is able to grow faster without the drag of taxes.
However, there are also some limitations and risks associated with 401(k) plans. One risk is that the value of the investments in the plan can fluctuate, which can lead to losses if the investments perform poorly. Another risk is that the funds in the plan are not accessible until the employee reaches age 59 1/2. If funds are withdrawn before then, they may be subject to income taxes and a penalty.
In summary, a 401(k) plan is a popular retirement savings vehicle that allows employees to save a portion of their pre-tax income for retirement. These plans offer a range of investment options and can also include employer matching contributions. While 401(k) plans have some limitations and risks, they are an important tool for many Americans to save for a comfortable retirement.