In 1981, the U.S. federal government decided that they needed to encourage people to begin saving for retirement, something beyond the realm of (and to ultimately reduce dependence on) social security. Offering tax breaks to those who participated was just the beginning of what Internal Revenue Code 401K had planned to establish.
How a 401K Works
Each employee decides on the amount of money (if any) that is deducted from each paycheck, up to a specific maximum annual dollar amount that the IRS sets each year. An employee also decides how their money will be invested in their 401K, choosing from a list of options within your plan’s provider.
The money that is deducted from your paycheck is taken out before your taxes are (also known as pre-tax ) most of time. This means that there is a very good chance that having your 401K funds deducted from your pay will actually reduce the income taxes you pay and increase the amount that you take home. For example, if your gross pay, before taxes, is $1,000 and you have 5% of your pay put into your 401K ($50), your federal income tax deducted will be based on $950 instead of $1,000. You pay no taxes on the deducted money ($50) until you withdraw funds from your account.
A few plans and 401K providers will allow you to have your deductions taken out after your taxes are, resulting in some taxes already being paid on the funds. The best bet is to consult your plan’s administrator to help decide on which scenario, either pre-tax or after tax, is best for your individual goals.
In 2006, the maximum contribution amount allowed by law is $15,000 as provided by the Economic Growth and Tax Relief Reconciliation Act of 2001. Each year, this amount will increase $500 to keep up with inflation. Each individual company can place a cap lower than this amount, but cannot exceed the federal limit.
The Difference Between a 401K and Saving for Retirement on Your Own
Many companies are providing a 401K for employees in lieu of a pension plan for retirees. Besides the phenomenal tax incentives that a 401K offers, many employers will “match” a portion of what you yourself put into your plan. The national average for such company matches is 50% of up to 6%. This translated into plain English means that whatever percentage you have deducted out of your pay, the company will put in half of what you put in for you, up to 6% of your pay.
For example, if you gross $1,000 (before taxes), and you have 6% of your pay deducted to contribute to your 401K, you would be putting $60 into this account. Your company matches 50% (half) of that $60 amount, or $30. So instead of you putting $60 away into your 401K retirement account, you have, in essence, put $90 away. Your employer has given you $30 for FREE towards your retirement.
Concerns of Your Company’s Future
In the unfortunate event that your company goes bankrupt, you need not worry about your investments. The Employee Retirement Income Security Act (ERISA) of 1974 mandates the manner in which your 401K money is maintained. Basically, your retirement fund is yours, not your company’s; therefore your 401K is not considered a company asset and cannot be touched or liquidated by them.
