Question: What is a 401(k)?
Answer: A 401(k) plan is an employee-funded retirement plan. It operates as a special kind of savings and investment plan established by employers under the federal tax code. Plans allow employees to invest pretax dollars for retirement and defer taxes on earnings.
Question: What are the advantages of a 401(k)?
Answer: Advantages of a 401(k) include:
- Tax-deferred earnings – employees’ don’t pay any federal, state, or local income taxes on this money or on the interest earned until the money is withdrawn
- Reduction in current gross income
- Automatic payroll deductions – the money employees put into a 401(k) is automatically deducted out of their paycheck, which makes saving easier
- Control over account, employees’ contributions to their 401(k) is always 100 percent vested
- No minimum investments
- Loan options
- Matching contributions – the company’s contributions to 401(k) are like employees receiving a bonus to help their savings grow steadily
- Social Security benefits are calculated on salary before 401(k) contributions are deducted, so employees still receive full Social Security benefits
Question: Who is eligible for a 401(k)?
Answer: To be eligible to participate in a 401(k), an individual must:
- Be a regular employee (temporary employees, independent contractors, and the like do not qualify)
- Be at least 21 years old
- Meet the time-in employment requirement
Question: When is the best time for employees to start contributing to a 401(k) plan?
Answer: The earlier the better! For example, let’s look at two people who have just started to contribute 6 percent of their annual salaries to a 401(k). Tom is 45 and Nina is 25. They both earn $20,000 a year. Suppose Tom works another 20 years before he retires, and Nina works another 40 years. When Tom retires, he should have a little over $50,000, but Nina will have more than $260,000!