401(k) plan is one of the greatest ways for employees to save for retirement. The government allows companies to offer retirement saving accounts -such as 401(K) accounts- indeed with some advantages to encourage people to save for retirement. However, if you are self-employed, you can also have a similar account for your retirement, known as a solo 401(k) or solo Roth 401(K).
What are 401(k) plan advantages?
- It is a tax-advantaged retirement account.
- It is a company-sponsored account.
- Federal law protects 401(k) retirement plans.
- You can get matching funds that I will explain below.
Two Basic Types of 401(k) Accounts:
- Traditional or Regular 401(k) is a pre-tax retirement investment. Meaning you will later pay tax on that money when you withdraw it in retirement.
- Roth 401(k) is a post-tax investment. This means that you have already paid your taxes; therefore, when you withdraw your fund, it is all yours –tax-free!
How does 401(k) work?
When you sign up for a 401(k) account, you set an amount or percentage that automatically will be taken out of your paycheck to fund the account.
Suppose you receive 100,000$ per year and contribute 10,000$ to your 401(k) account. With traditional 401(k), the amount you contribute to your 401(k) fund is deducted from your taxable income. For example, in this case, your total taxable income for the year would 99,000$. The money that you put into a 401(K) account is tax-deferred; meaning you don’t pay taxes on it until you withdraw it in retirement. Therefore, your money in your 401(k) account can grow without being taxed. However, with traditional or regular 401(k), you eventually have to pay taxes on your withdrawals.
On the other hand, some companies offer Roth 401(k) for their employees. With the Roth 401(k), your contributions are not tax-deferred. It means that whenever you get your paycheck, first, the taxes will get taken out from your salary or wages check, and then you will fund your Roth 401(k) with whatever is left. In other words, your contributions are made with after-taxed money. The bottom line is that your contributions are made with post-taxed money. So while Roth 401(k) does not give you any tax benefits today, it will give you huge tax benefits later on; because your withdrawals will be tax-free, and all will belong to you.
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Many employers offer to match your 401(k) contributions. It means that if an employee puts some of his/her money into a retirement account, the employer will put some extra money in there too. Therefore, if your company offers you a matching contribution program, you must accept it; because it is like free money or a pay raise. Companies have different formulas and calculations to do that. The most common way is to match a percentage of an employee’s contribution, up to a certain limit. For example, an employer may match 25% of your contribution. It means that if you put 10,000$ in your retirement account, the company will match 25% of that (i.e., it will put 2,500$ there). It is like free money or a pay raise, and not taking advantage of that means you leave “free money” on the table and say: no, I do not want that.
What is 401(k) rollover? The question may arise if you have an old 401(k) from your previous employer; or if you have changed a job and are wondering what to do with your 401(k) account. In that case, you will have three options:
- 401(k) Rollover: a 401(k) rollover is a transfer of money from an old 401(k) to a new 401(k) account or IRA (Individual retirement account).
- Keep your 401(k) with your former employer.
- Cash it out. Casing out a 401(k) is not usually a very good idea. Because if you withdraw your money before its due time, there are penalties for early withdrawals.
*if you don’t know which choice is best for you, depending on your unique situation, you may want to consult with a tax professional to make sure that you are making the right decision. Sometimes the wrong and unthought decision can cost you dearly.
Guide to 401(k) Rollover
- You may roll over your old 401(k) to a new retirement account when you leave your job. There are two types of rollovers: direct and indirect. In a direct rollover, your previous money account is transferred electronically to your new account. In an indirect rollover, you receive the money in your fund to redeposit it. If you receive the money in cash or check instead of transferring it directly to the new account, you only have 60 days to deposit the fund into your new retirement account. And once more, remember that this must be done within 60 days. If you miss the deadline, you will be subject to withholding taxes and other penalties. Between direct and indirect rollover, the direct one (with no check) is the best.
- Decide what kind of account you want and then open it; that is to say, decide which type of new retirement account suits you well. Note that your age –how old are you and how far you are from approximate retirement age- and your risk tolerance are among the important factors that should be taken into account in this decision.
- You have to choose a financial institution, such as a bank, brokerage, or online investing platform to open a new retirement account.
- See what is needed to begin the 401(k) rollover process.
Now you know that if your company offers a 401(k) plan or any contribution matching program, you have to accept it definitely and undoubtedly. The best way to reassure that your organization offers you this retirement plan is to go to your human resource department. If you work for a small company that does not have an HR representative, the next best person to talk about would be your boss or employer.
“If you have any feedback about how to roll over an old 401k that you have tried out or any questions about the ones that I have recommended, please leave your comments below!”
NB: The purpose of this website is to provide a general understanding of personal finance, basic financial concepts, and information. It’s not intended to advise on tax, insurance, investment, or any product and service. Since each of us has our own unique situation, you should have all the appropriate information to understand and make the right decision to fit with your needs and your financial goals. I hope that you will succeed in building your financial future.