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Ask The Advisor - 401(k) Plans

Ask The Advisor - 401(k) Plans

April 29, 2024

A 401(k) plan is a tax-advantaged savings plan established by for-profit companies as a benefit for their employees.

401(k) plans are considered “defined-contribution” plans which have gradually phased out the old pension or “defined-benefit” plan. Instead of a fixed dollar amount promised in retirement by your employer, it is up to you the employee to save and “contribute”, up to an annual limit, and invest those savings in financial markets through mutual funds your company provides for you.

Here’s how they work: You contribute a percentage of your paycheck to your 401(k)-investment account and allocate the money among a provided set of investment options to create an investment mix that suits your risk tolerance and investment time horizon.

Key Benefits:

  • Tax advantages: Traditional 401(k) contributions are made before tax, which reduces your taxable income and tax obligation in the current year. Withdrawals in retirement would be taxed at your ordinary income tax rate. Roth 401(k) contributions are taxed now, but your withdrawals in retirement are tax-free and usually popular for younger employees. This means your investments grow inside the plan without being taxed on interest, dividends, or capital gains.
  • Employer contributions: Many employers match your contributions up to a certain percentage of your salary, usually 3%, so it is important to contribute enough to receive the match from your company if you can.
  • Investment options: You choose how your money is invested, from less risky bond funds to potentially high-growth equity funds.
  • Portability: You can take your 401(k) with you if you change jobs or roll all of it over into an IRA, depending on your company’s vesting requirements.

Things to Consider:

  • Contribution limits: There are annual limits on how much you can contribute to a 401(k). In 2024, it's $23,000 for most people, with an extra $7,500 catch-up contribution for those 50 and over.
  • Early withdrawal penalties: Withdrawing money before age 59 ½ usually comes with a 10% penalty but taking a loan from your 401(k) is an option. However, you can withdraw from a 401(k) without any penalties at age 55 if it’s the company you’re retiring from after age 55.
  • Vesting: Some companies will require you to work for so many years to fully earn the company match; if you leave the company before fully vested, you might lose some of your employer’s contributions.
  • Solo 401(k): An option for a business owner with no employees; IRS rules say you can’t contribute to a Solo 401(k) if you have full-time employees, though you can use the plan to cover both you and your spouse.
  • If a company fails and enters bankruptcy, its 401(k) plan assets are almost always protected. The same cannot be said for pension plan assets because the employee controls the investments in a 401(k) plan, not the employer.

Overall, a 401(k) is an important tool to save for retirement and benefit from tax advantages and employer contributions. Remember to start saving early and make the most of your plan. It would be prudent in our view for an investor to have a mix of traditional and Roth style accounts after consulting with a financial advisor.


Important Information:

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