A 401(k) is a qualified tax deferred compensation retirement plan, established by employers, in which an employee can elect to have part of his/her wages contributed to the plan, on a pre-tax basis.
Many employers offer matching contributions on behalf of participating employees and may also add a profit-sharing feature to the plan. The earnings grow tax deferred (you do not have to pay taxes on any amount until its withdrawn), and the contributions are tax deductible.
401(k) Pros and Cons
A qualified 401k plan is an expensive employee benefit, since there are so many compliance issues, and requirements that must be upheld to maintain the accounts properly. All of the participation fees associated with this plan, are inadvertently passed onto you, the holder of the retirement account. Record keeping is a labor-intensive endeavor, and requires many years of reporting, that can give way to erroneous data and mistakes.
Many 401k plans allow employees to make a hardship withdrawal because of immediate and heavy financial needs, but you can’t withdraw your money just because you want to if you still work for that company. Generally, hardship distributions from a 401k plan are limited to the amount of the employees’ elective contributions only, and do not include any income earned on the deferred amounts. If you can prove you’re taking the money out as a hardship need, you will still have to pay a 10% tax penalty if you’re under the retirement age requirement.
Contributing to a 401k does however, give you some tax benefits. Depending on your gross income, you may qualify for a tax deduction, decreasing the amount of your taxable income, and even qualify you for a non-refundable Saver’s credit. However, if you have a loss on your 401k investment, you can’t take it as a tax deduction. You will be required to take minimum distributions (MRD) from this plan when you reach retiring age, and all the money will taxed at your current income level. Sometimes you can defer the MRD, but it’s limited by the Internal Revenue Code.
Definition of a Roth 401(k) retirement account
A Roth 401k a much more flexible and beneficial account versus a regular 401k. It is defined under the Roth IRA rules, rather than the normal 401k restrictions. This account allows the taxpayer to set aside after-tax income up to the income restriction amount dictated by the IRS. There are no minimum required distributions to take out and you can keep earning interest and save your funds in your IRA as long as you live. The earnings grow tax free, and you do not have to pay ordinary income tax. Unlike the regular 401k, the contributions are not tax deductible.
Here is a little-known fact about these retirement accounts – You can contribute to a regular a Roth 401k while still having a regular Roth IRA. They are all considered different retirement accounts, so you can contribute to any combination of them. You still need to check with your accountant or tax professional to confirm your income and contribution limits.
Are you saving for retirement, what kind of account(s) do you have?
