401(k) Benefits: 5 Reasons To Consider A 401(k) Retirement Plan
PUBLISHED: Apr 12, 2023
Opening a retirement plan is a great way to financially prepare yourself for the future. But with so many options to choose from, it can be difficult to find the plan that works best for you. A 401(k) is a popular option that many employers offer, and it provides several benefits to participating employees.
Let’s walk through some of the benefits of a 401(k) retirement plan. Then, you can determine whether a 401(k) is the most practical way for you to save money for retirement.
What Is A 401(k)?
Before we dive into 401(k) benefits, let’s establish exactly what a 401(k) is and how it works for employees and employers.
A 401(k) is an employer-sponsored retirement plan, which means your employer sets up the account for you rather than opening it on your own. Employees contribute a portion of their salary into their 401(k). Then, depending on the organization’s 401(k) plan, employers may match the contributions up to a certain amount.
When opening a 401(k), the employee can choose how to allocate their money across the investment options that the company offers. These investment products are typically mutual funds.
Employers pull individual contributions automatically from each paycheck, so employees don’t have to worry about manually adding funds to their 401(k) account. This makes it easier to save.
5 Benefits Of 401(k) Retirement Plans
A 401(k) retirement account offers several benefits for employees. Up next are some of the reasons many employees choose to open a 401(k) plan to prepare for retirement.
1. Tax Advantages
Opening a 401(k) comes with an array of tax benefits. For example, the money you contribute to a traditional 401(k) is pretax (unlike a Roth 401(k), where contributions are already taxed). This means that the funds you set aside from each paycheck for your 401(k) are taken out before taxes.
So, you end up paying taxes on a smaller annual salary because the money that’s already been allocated to your 401(k) isn’t accounted for. Since your taxable income is lower, you may also qualify for a lower tax bracket, which could result in paying a smaller tax bill when tax season rolls around.
You don’t have to worry about paying taxes on your contributions until you cash out the 401(k) when you retire, which is age 59 ½ at the earliest.
Finally, the money you invest with a 401(k) is tax-deferred. Translation: The longer your money sits in the 401(k), the longer it continues to grow, tax-free. Plus, this money has the potential to compound over time. In other words, you can reinvest the earnings on your 401(k) investments and generate even more earnings in time.
2. Employer Matching
Employer matching is another advantage of signing up for a 401(k) plan. Because opening a 401(k) is voluntary, many employers offer matching as an incentive to encourage employees to sign up for the retirement plan.
Contribution matching policies vary depending on the company, but most employers will match either 50 cents to the dollar or dollar for dollar up to a certain amount of money. Some companies may offer employer matching right when employees open a 401(k), while others may begin matching after a year or two of employment.
Just like with employee 401(k) contributions, employer contributions and any earnings on these contributions are tax-deferred. Because this is often considered “free money,” employees are typically encouraged to allocate enough money to qualify for the entire employer match.
3. High Contribution Limits
Contribution limits are higher for 401(k)s than other retirement plans. For 2023, the employee contribution limit is $22,500 – up from $20,500 in 2022. Employees age 50 or older also benefit from the catch-up contribution limit, which adds $7,500 to your annual contribution.
In comparison, the contribution limit for an individual retirement account (IRA) is capped at $6,500 in 2023 (or $7,500 if you’re 50 or older).
Contribution limits are also established for the amount an employee and employer can collectively contribute to the 401(k). Annual additions, or the total of all employer and employee contributions and forfeitures paid to an employee’s 401(k) account, can’t exceed the lesser of the following options for 2023:
● 100% of the employee’s annual compensation
● $66,000 (or $73,500 if you include catch-up contributions)
4. Flexibility When Leaving A Job
Another advantage of opening a 401(k) account with an employer is that participants may have options if they decide to leave their company. Depending on the specifics of the 401(k) plan, you usually have four options.
According to the Internal Revenue Service (IRS), these options include:
● Leaving your money in the current 401(k) plan: You may have the option to maintain the balance in your old 401(k) account, especially if you benefit from the plan’s low fees or investment opportunities.
● Transferring your money to a new employer’s 401(k) plan: You might be able to roll your existing balance over into your new employer’s 401(k) account.
● Rolling your current balance into an IRA: You may have the option to transfer your funds from the old 401(k) into a traditional or Roth IRA plan.
● Withdrawing your current balance from the 401(k): You may be able to withdraw the money from your 401(k), but at the cost of incurring an early withdrawal fee and/or paying income taxes on any untaxed funds.
Make sure you fully understand your current employer’s 401(k) policies before deciding how to handle the funds in your retirement account.
5. More Control Over Your Retirement Savings
Compared to other retirement plans, 401(k) accounts tend to give employees more control over what they do with their retirement savings. For example, most participants can increase or decrease the percentage of their contributions at any time.
Because 401(k) contribution limits are higher than other retirement accounts, you can also contribute as little or as much money as you want (up to $22,500 in most cases).
Drawbacks Of 401(k)s
While 401(k) plans have numerous benefits, they also come with drawbacks you may want to consider before opening an account with your employer. Below are some disadvantages of 401(k)s.
Required Withdrawals
Plan participants must start taking required distributions out of their 401(k) account after they reach a certain age.
Depending on your company’s 401(k) policy, you’ll receive the entire amount or begin receiving required minimum distributions (RMDs). The administrator of your company’s 401(k) plan will determine the amount distributed to you every year.
According to the IRS, the date you’ll start receiving distributions from your 401(k) is April 1 of the first year after what’s later between:
● The year you turn 72 years old (or 70 ½ if you reached that age before January 20, 2020)
● The calendar year you retire
Even if you don’t retire by the time you reach 72 years old, you may still be required to receive distributions (by April 1 following the year you turn 72). The specifics of when you may start receiving RMDs can depend on your retirement policy.
Early Withdrawal Fees
Typically, you’ll have to reach a certain age before you can start withdrawing funds from a 401(k) plan. Age 59 ½ is the earliest you can access your 401(k) funds – and if you try to take money out before reaching 59 ½, you’ll likely have to pay an early withdrawal penalty.
Unless an exception applies to the early withdrawal, you’re required to pay a 10% early withdrawal tax. To see whether you can withdraw funds from your 401(k) early, review the IRS page on exceptions to the tax on early distributions.
Few Investment Options
When opening a 401(k) through your employer, you get to decide how to allocate your money among different investment products. While you ultimately select the investments, your employer is in charge of picking the investment options from which you can choose.
These investments are sometimes limited, so you may miss out on other investment opportunities simply because your employer didn’t opt to offer them.
The Bottom Line
A 401(k) gives you the freedom to choose the amount you want to contribute toward retirement. Also, the 401(k) tax benefits and high contribution limits are important considerations when deciding among different retirement accounts.
If you’re interested in opening a 401(k) with your employer, or you’re already contributing to your 401(k), consider connecting your account with the Rocket Money℠ mobile app. The app allows users to keep all of their accounts – from checking accounts to retirement plans – in one place, and it provides a detailed view of your investments, net worth and more.
To learn more, create an account on the Rocket Money app today.
Victoria Araj
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