What are 401(k) Plans? | Definition & examples


American employers provide retirement savings plans with tax advantages, offering various investment options, including the popular 401(k) plans. They can ask the employees to sign 401(k) and allow them to deduct a particular amount as employees’ contributions. The deducted funds get invested in employees’ choice funding from a list of offerings. 

Based on the chosen plan, the employee may get a tax break while contributing the money or withdrawing at retirement. Apart from employees, the employer also contributes an equal amount to the fund.

401(k) plans in a nutshell

  • Employers offer tax-advantaged 401(k) retirement plans with diverse investments.
  • Employees contribute pre-tax to 401(k), choosing from a list of investments.
  • Traditional 401(k) provides tax benefits on withdrawal, deducted from gross income.
  • Roth 401(k) offers tax-free withdrawals, deducting contributions from after-tax income.

Working of 401(k) – Two options explained

The American government developed this plan to encourage savings until retirement and offer tax advantages as incentives. Two options exist with unique tax edges:

Traditional 401(k)

A traditional 401(k) deducts employee contributions from the gross income. Gross salary is money before income tax gets cut. It reduces an employee’s taxable income by the total contribution amount for the year and gets reported under tax deductions in the tax statement. No taxes become due on the contributed earnings or investment money until the employee withdraws, usually at retirement.

Roth 401(k)

The Roth 401(k) plan calls for deducting contributions from the after-tax income, meaning income tax has already gotten subtracted. Therefore, no tax deduction is available for the contribution in this plan. However, when the time for withdrawal comes during retirement, the employee bears no additional taxes on the contribution or investment earnings.

Every employer does not offer the choice of Roth. Instead, employees can choose one or a mix of both up to specified limits on their tax-deductible contributions if they do. In addition, although employees are free to withdraw the invested funds during retirement, they will have to pay penalties if they do it early. 

Example of 401(k)

Let’s help you understand 401(k) with this example. 

Suppose the company ABC offers its employees the choice of signing up for traditional 401(k). An employee named Bobby undertakes the offer. His pre-tax paycheck comes to $1000. He chooses to contribute 10% pre-tax contribution from his income, which comes to $100. These $100 get invested in his preferred mutual funds to make up his plan.

Benefits of 401(k)

The following points illustrate the advantages of 401(k) plans for employees:

BenefitExplanation
Employer’s contributionBoth employee and employer contribute equally to the investment fund for the former. It allows for higher savings and tax edges. 
Less painful savings with pre-tax contributionsChoosing the pre-tax contribution option enhances the size of your savings.
Lower-income taxesPre-tax contributions deduct an amount from your income and allow the rest to get taxed. Thus, the income tax contribution for the current year’s earnings reduce. 

Bottom line

401(k) plans allow employees to invest their money in the securities market and save a significant amount simultaneously for retirement. Withdrawal restrictions on the plan enable it to grow and enjoy tax savings.

About the author

Percival Knight
Percival Knight is an experienced Binary Options trader for more than ten years. Mainly, he trades 60-second trades at a very high hit rate. My favorite strategies is by using candlesticks and fake-breakouts

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