A 401k is a retirement savings vehicle funded by employee contributions and often by matching employer contributions as well. The great thing about 401k investments is that contributions to these plans are taken from the employee's salary on a pretax basis, so the money that goes in has not been taxed when it's deposited, and is allowed to grow free of taxes until it is withdrawn upon retirement (or sooner if necessity so dictates). 401k accounts are fairly self directed, meaning the account holder has a fair amount of control over what funds he or she wants to invest in and things of that nature. Companies that operate for a profit and nonprofit organizations are both welcome by law to set these plans up for their employees.
The U.S. tax code is the basis for all rules and regulations that pertain to 401k accounts. As a matter of fact, the name of these plans comes from the part of the Internal Revenue Code of 1978 that brought them into being. The Internal Revenue Service dictates the rules on these plans, but they are not their overseers. That job belongs to the Employee Benefits Security Administration, a division of the United States Department of Labor. Section 401 of the Internal Revenue Code of 1978 created and defined qualified plan trusts, and set the rules that such trusts had to follow in order to qualify. Section 401k of the code creates the provision for an optional cash or deferred method of getting employee contributions.
401k plans are very popular all across the country. Probably the biggest explanation for their popularity is that there are so many pluses associated with getting into one of these investment vehicles. The first advantage most people would point out is that the pretax contributions not only provide untaxed monies in these accounts, but also reduce the employee's overall tax basis for the year. Contributions for the long term are rewarded on the short term with tax benefits on multiple levels. Tax coming out of every pay check is reduced, significantly cutting down on the drop in take home pay for those who sign up for a 401k, and there are even options for 401ks for the self employed.
Second, these accounts are set up so that all employer contributions and any money the accounts earn grow tax free until withdrawal. This means that you're essentially getting free money from your boss, and that free money is being allowed to compound for years on end until it finally gets taxed...once. The compounding effect of even small systematic contributions can really lead to large balances at the close of the accounts upon retirement.
And third, the account holder has the ability to direct future contributions, allowing the account holder a large degree of control over the investment. And what's more, at a lot of companies the employer matches contributions from employees (at least to a certain extent); meaning workers are getting free money that they did not work for. Even those of us who have other retirement investments would be silly not to take advantage of free retirement money. At the very least, contribute the minimum amount needed to maximize the employer contribution. Thanks to tax advantages, a six percent pretax contribution may only result in a four percent drop or so from your take home pay. And for this you get your employer's three percent as well. Not bad math for most of us.
401k accounts are a great option for company employees who are just getting started with a retirement strategy. Contact a financial advisor for more information.
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