What is a 401k Account?

By Eddie V. — Published March 14, 2018

What is a 401k Account?

A 401(k) plan is a savings plan for your retirement, legally offered by your employer. A portion of your paycheck is taken out and transferred to your 401(k) account, before the deduction of taxes.

The plan is named after the section of the Internal Revenue Code that governs it, that is, subsection 401(k). It came into prominence around the 1980s, when employers realized that running pension funs was getting way too expensive. Pensions funds were paid by employers to employees after retirement on a regular basis, but this soon proved to be extremely expensive, and therefore, 401(k) plans were introduced.

If you have a 401(k) plan, you do not have to pay income taxes on the amount that is transferred to your 401(k) account for that particular year. This amount should fall under the legal contribution limit and is known as a salary deferral contribution. You defer a portion of your salary into your 401(k) plan and save it for your retirement.

Whatever amount is inside the account, it increases tax-deferred, which means that as the money grows with investment income, no taxes will be due on the gains every year. Instead, you will be required to pay tax at the time of withdrawal of the money, when you retire.

However, if you withdraw your money before your retirement age, you will have to pay a penalty of 10 percent, including your income taxes. This is done by employers to ensure that their employees do not leave them way too early.

Types of 401(k) contributions
There are three different types of contributions that employers make to your 401(k) account. These are always pre-tax, meaning that they can be taxed only when you withdraw them at retirement.

Here are the three types of 401(k) contributions made by employers.

• Matching
A matching contribution is where your employer puts in money to your plan that will match your own contribution. This means that employer contributions are made only if the employee himself or herself contributes. A matching contribution of 3 percent is usually the most common. For example, if you make $50,000 a year, you put in 3 percent of it, which is $1,500 into your plan. Your employer also puts in another $1,500 to match your contribution.

• Profit sharing
A profit sharing 401(k) contribution is where your employer contributes a set amount of dollars to your plan, if the company receives a profit. Although many companies follow various formulas to determine the amount of contribution employees can get, the most common is that each employee with a 401(k) plan will receive a contribution proportionate to his or her pay.

• Non-elective
A non-elective contribution is where an employer contributes a set percentage to each employee’s 401(k) account. Even if an employee does not contribute his or her own money to the plan, the employer will still make the set percentage contribution. For example, the company may contribute a set 3 percent of pay to all eligible employees’ 401(k) plans every year.

Designated Roth 401(k) plan
Apart from the traditional 401(k) plan, there is also another type, known as Roth 401(k) plan. However, fewer companies provide this type of plan.

Established back in 2006, the main differences between a traditional 401(k) plan and a Roth 401(k) plan lie in tax implications, and accessibility of funds. While funds in a traditional 401(k) plan are taxed at the time of withdrawal, Roth 401(k) contributions are made only after tax deductions. This means that you won’t have to pay any taxes when you withdraw at the time of retirement.

Another difference is that while funds in traditional 401(k) plans cannot be accessed before retirement, and a penalty has to be paid if you do so, Roth 401(k) funds can be easily accessed any time as long as you have had the account for 5 years or more.

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