A 401(k) is a type of retirement savings plan offered by many employers in the United States. It allows employees to save and invest a portion of their paycheck on a tax-deferred basis and often includes an employer match that can provide an additional source of retirement income.
The main benefit of a 401(k) is that it allows employees to save for retirement on a tax-deferred basis. This means that employees can contribute to their 401(k) account with pre-tax dollars, which can reduce their taxable income and save them money on taxes. In addition, the investment earnings in the account grow tax-free until they are withdrawn in retirement.
For example, suppose an employee earns $50,000 per year and contributes $5,000 to their 401(k) account. If they are in the 25% tax bracket, this contribution would reduce their taxable income to $45,000, and they would save $1,250 in taxes ($5,000 x 25%). In addition, the investment earnings in their 401(k) account would grow tax-free until they are withdrawn in retirement.
Another benefit of a 401(k) is that many employers offer a matching contribution, which can provide an additional source of retirement income. For example, an employer may match 50% of an employee’s contributions up to a certain amount, such as 3% of their salary. In this case, if the employee contributes $5,000 to their 401(k) account, the employer would contribute an additional $1,500 ($5,000 x 3% x 50%), for a total contribution of $6,500.
In addition to the tax benefits and employer matching contributions, 401(k) plans also offer a wide range of investment options. Most plans offer a variety of mutual funds, as well as individual stocks, bonds, and other securities. This can provide employees with the opportunity to diversify their investments and potentially improve their returns.
One of the drawbacks of 401(k) plans is that they have contribution limits. For 2021, the maximum contribution that an employee can make to their 401(k) account is $19,500, or $26,000 if they are age 50 or older. This means that employees who want to save more than these limits may need to look for other retirement savings options, such as a traditional or Roth IRA.