401(k)

A retirement savings plan offered by many American employers

401(k) is a retirement savings plan sponsored by an employer. It allows employees to save and invest a portion of their paycheck before taxes are taken out. Taxes aren't paid until the money is withdrawn from the account.

History

The 401(k) plan was established by the Revenue Act of 1978, which included a provision that became Internal Revenue Code (IRC) Section 401(k). This provision was initially intended to allow taxpayers a break on taxes on deferred income. The first plans began to be offered in 1980, and they gained popularity as a retirement savings vehicle in the 1980s and 1990s.

How it Works

Employees can choose to have a portion of their salary paid directly into their 401(k) account. The contributions are deducted from the employee's gross income, meaning they are not subject to income tax at the time of contribution. Employers may also make matching contributions to a 401(k) plan, which can significantly increase the value of the account over time.

Contribution Limits

The Internal Revenue Service (IRS) sets annual contribution limits for 401(k) plans. For 2023, the contribution limit is $22,500 for individuals under age 50, with an additional catch-up contribution limit of $7,500 for those aged 50 and over.

Investment Options

401(k) plans typically offer a range of investment options, including mutual funds, stocks, bonds, and money market funds. The specific options available depend on the plan provider.

Tax Implications

Contributions to a 401(k) plan are made on a pre-tax basis, which reduces the employee's taxable income for the year. The funds in the account grow tax-deferred, meaning taxes are not paid on the earnings until they are withdrawn. Withdrawals are taxed as ordinary income.

Required Minimum Distributions

Starting at age 73, account holders must begin taking required minimum distributions (RMDs) from their 401(k) accounts. The amount of the RMD is based on the account balance and the account holder's life expectancy.

Advantages and Disadvantages

Advantages

• Tax Benefits: Contributions reduce taxable income, and earnings grow tax-deferred.
• Employer Match: Many employers offer matching contributions, which can significantly boost retirement savings.
• High Contribution Limits: Compared to other retirement savings options, 401(k) plans have relatively high contribution limits.

Disadvantages

• Limited Investment Options: Investment choices are limited to those offered by the plan provider.
• Early Withdrawal Penalties: Withdrawals before age 59½ may be subject to a 10% penalty in addition to income taxes.
• Required Minimum Distributions: Account holders must begin taking distributions at age 73, which can affect tax planning.

Also see

• Individual Retirement Account
• Roth 401(k)
• Pension
• Social Security (United States)

References

• Retirement Topics - 401(k) and Profit-Sharing Plan Contribution Limits - IRS
• 401(k) Plan - Investopedia