It is a Great Method to save Before Retirement and Reduce Taxes
You must not get confused with the strange sounding name of the plan. These are easy to understand retirement plans offered by certain employers in the US. The name has been derived from the Internal Revenue Code’s relevant section.
Benefits with Taxes
An important benefit of a 401(K) plan is the way contributions should be made on the basis of pre-tax. When you are an employee, you have the option to make pre-tax contributions into the plan with salary deferral. As the contributions are made pre-tax, you need not pay any income tax on the money contributed to the plan.
While you reduce your tax payment with the contribution, you also get an interest on the money you contribute. Your tax payment will be differed and you need to pay tax only when you withdraw your money and it will be treated as ordinary income then.
Some of the employers match the employee’s contribution with their own contribution to these plans. Some companies pay an equal amount while there are others that contribute a percentage of what the employee has contributed.
Additionally, some employers may impose a vesting schedule in which case the employee has to serve for a certain period of time before he is able to withdraw what company has contributed. This vesting period could either be continuous or on a graduated scale.
Choices of investment
A plan of 401(K) could provide you the opportunity to invest the money in many ways. They could be investment with stocks, money markets or bonds, guaranteed investment pools or annuities, company stocks or in brokerage accounts found by the employee. Majority of the plans offer some option for you to get a good retirement portfolio.
You are allowed to withdraw money from these accounts for five different reasons.
- At the end of employment
- When you reach the age of 59½ ( in some cases 59)
One important thing you need to note is that in case you withdraw the money before reaching the age of 59½, you are liable to pay a 10% penalty for early withdrawal, imposed by IRS. In addition to the five causes above, you have the option to withdraw a portion as a loan in case your plan has provision for that.