What Is A 401k Plan And How Does It Work?

Definition of "What is a 401k plan and how does it work?"

Cheree Graham real estate agent

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Cheree Grahamelite badge icon

Keller Williams Realty at The Parks

It’s time you started thinking about your retirement years! Don’t let old age take you financially unprepared! It can be nerve-wracking to wake up one day without a nest egg to cover your everyday cost of living. But, your very existence could depend on thinking ahead! Begin planning for early retirement now!

Nonetheless, we did not forget about the demanding responsibility to pay off your mortgage either. At a specific moment, you will have to consider: invest in your 401k or pay off your home.

The untold psychological side of retirement

In some cases, reaching retirement can be pretty stressful anyway. Breaking away from the daily routine and getting used to another, more carefree and calmer lifestyle, paradoxically, may sound like an unexpected psychic burden to a few ex-workaholics. A little similar to the Stockholm Syndrome or being addicted to prison life even after release, retirement does not always come just with sunshine and bliss. Don’t listen to people claiming that money can’t buy you happiness! It surely can provide you with a little peace of mind. After a prosperous lifetime’s work, you deserve this! Leave your troubles behind; a 401k works just fine when you retire!

Learn how to contribute to retirement funds!

Today, one of the most widespread methods to save for retirement is contributing to a 401k plan, in short, a retirement savings account. You willingly submit a certain amount of each paycheck. Nevertheless, only an employer can give the green light to finance a 401k for their staff members. It’s up to you to determine how much money you intend to withdraw from your monthly wage and, subsequently, be accumulated into the plan. 

Tax reduction, a huge benefit of the plan

The amount you contribute is deducted from your taxable income. For example, the average national income in America for 2021 is approximately $80,000. Let’s say you have decided to add $10,000 to the 401k plan from your annual salary. This action automatically reduces the amount of taxes you have to pay for 2021 by $10,000. For this reason, your total taxable income for this year will be only $70,000!

Moreover, the amount you contribute to retirement funds will grow tax-exempt until you leave your workplace and decide to withdraw the money from your bank account. 

IRS rules, however, set a clear limit to monthly deposits. Sometimes, your manager can also make contributions to your plan, but they don’t have to.

A slightly better alternative for the old age - Roth 401(k)

The gist briefly goes as follows. Since you have already paid taxes on your contributions, the withdrawals you make in retirement are tax-deferred. The sole condition to this is to have an account funded for a minimum of five years. A small reminder: if you opt for a simple 401k, you'll have to pay taxes on the amount you remove from your account based on the current tax rate after retirement.

We recommend the Roth 401(k) Plan for individuals who consider they will be in a higher tax bracket in retirement than they are now. A tax bracket implies a scope of incomes subject to a specific income tax rate.

We must mention the downside of the story. You must count with a more considerable after-tax contribution from your actual salary than a pretax contribution to a traditional 401(k) Plan. After-tax contributions will not be followed by a tax deduction and shall be taken out of your pocket after it has been taxed.

Historical roots of the 401(k) plan

The name of 401(k) plans comes from the section of the tax code (Internal Revenue Services, IRS, Code) that governs them. It was thought up and became part of the vernacular during the 1980s as a supplement to pensions. Notably, the US government outlined this plan to encourage people to save for retirement with distinct tax advantages. Therefore, employees would be motivated to actively contribute to a 401k. Up to that moment, average companies and employers used to offer pension funds. High executives managed these funds that provided employees retirement income. Explicitly, employers paid a stable income to the aging workforce over the years of retirement.

Be smart with your retirement funds in 2021!

Only in one specific aspect did it change from the previous year. The 401k contribution limits remain the same in 2021. The elective deferral, namely, the maximum contribution you are allowed to make to a retirement account directly from your wage, is $19,500. The limit of the additional amount to the fund, namely the catch-up contribution, is $6,500 but only for at least 50 years old. The changing aspect is the limit for employers and employee contributions raised to $58,000 from $57,000.

We highly recommend you start working on your retirement funds! Hopefully, this piece addresses your burning questions and clears eventual doubts about how to pick investments for 401k in 2021. You never know what the future brings, and a dollar now put aside is a dollar well-earned. We wish you a pleasant retirement free of worries!

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