Traditional 401(k) plans are retirement plans sponsored by employers where a part of employee’s salary is directly deposited in a 401(k) account before tax is deducted from it (pretax). The ‘part’ deducted from the salary is known as ‘contribution’. Often even employers choose to match a percentage of the employee’s contribution to be deposited in the 401(k) account. These contributions make the principal amount of the retirement plan where these funds are in turn invested (in bonds, stocks, mutual funds etc) to maximize earnings from the savings. This translates to savings for retirement as well as imparting growth to employee’s money. And the best part is that all the earnings from such investments are not taxed until a withdrawal is made from the fund.
Generally, the company where a person works is the one who sponsors and offers the 401(k) plan. To be eligible to be enrolled into the plan, an employee has to complete one year of service with the company. Also, it is essential to understand that by law, the company cannot make an employee wait any longer than the stipulated year period to start contributing to the plan.
Contributing to the 401(k) account is essential if one desires to retire with good amount of savings. It is wise to start contributing as early as possible. No matter if it is only 1-3% initially; it’s still a start. A general rule of thumb that applies to a 401(k) account is that one should contribute as much as one can to the 401(k) account since part or all of the funds are used for investments as well. Hence, the more money one puts in, the more chance that money has to grow and give fruitful returns in the long term.
Also, one should not stop contributing to the 401(k) account. Even if one is unemployed or is going through financial troubles, one should contribute to the account as much as possible. Some people think that that they should stop contributing in a slow market which may inadvertently turn out to be a big financial mistake. Contributions from a 401(k) account are used for investments which are mostly long term, especially for younger employees. A slow market can in fact be a good time for investing as the prices of equities are low, providing an opportunity to invest more by getting better deals. This translates to greater earnings in the future where the market is expected to grow.
Many employers match a percentage to the employee’s contributions; some even $1 for $1 up to 5% of total contribution which is a 100% return on investment. There are hardly any investments which offer such high returns. Hence it is essential to ‘bank’ on this free cash as it increases the total amount in the account, resulting in fruitful gains in the long term.
There are also limits to how much an employee can contribute to their 401(k) account in a year. The limits also vary for different types of 401(k) plans. Every company has a different 401(k) plan and so these limits vary accordingly and may limit the percentage of salary that the employee may contribute to the account. There are also federal limits (that change annually) which cannot be exceeded. As per the federal limits for the year 2010, employees can contribute a maximum of $16,500 or 100% of their salary, whichever is lower, to their 401(k) plan. Employees of age 50 or older can contribute an additional ‘catch-up’ amount of $5,500 as well. If one has multiple 401(k) plans, these limits apply to them cumulatively. This means that if one has two 401(k) plans, the total contributions to both these plans should not exceed the specified limit. In addition to these rules there are also rules that govern the contributions of ‘highly compensated employees’ (HCE) who may be eligible to a second contribution limit. Such employees should check with their employer or plan administrator to work out the details for proper planning.
It should be noted that these figures do not include the employer’s contribution. Since employer’s match is excluded from the limits, it becomes all the more important to contribute as much as one can as the employer will match additional percentage which can help maximize gains from the 401(k) account.
Proper financial planning should be taken up when dealing with the 401(k) account, its funds and investments. Since contributions form an essential part of the account, managing them is of utmost importance. One should not only start contributing as early as possible, but should also contribute more in the earlier years of employment. The main reason for this is that as one progresses in their career and tenure, their pay increases, pushing them into higher income tax bracket. Also in the unfortunate circumstances that one faces financial troubles or declares bankruptcy, the court protects one’s retirement funds. Hence saving as much as one can in the account will prove as leverage and a ‘coming-back’ vehicle in such unfortunate future times.
A great advantage that the 401(k) account provides is that all the funds in the account are made up of pre-tax dollars. And pretax dollars offer wide advantages when it comes to investing and imparting growth to the money. Also in times of hardships, these pretax dollars can be utilized accordingly without attracting income tax.
Understanding how essential contributions are for one’s retirement savings can go a long way in providing a great retirement. One should review their 401(k) plan and account quarterly or at least yearly and plan their contributions accordingly. When opening a 401(k) plan the employee should also go through the literature of the plan and gain at least basic understanding of the plan and its facilities. And if one finds it hard to manage, one can always opt for a tax lawyer who can simply take care of the details and also provide advice to maximize the savings.