What is a 401(k)? Explained

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What is a 401(k)? The 401(k) is one of the most common retirement savings accounts. It is set up by your employer and has both tax and savings advantages. If we think of a person who just started a new job with an insurance company. One of the perks of this job is 401(k) matching, Now we’ll see how it works.

If the person earns $100,000 before taxes and is allowed to put up 6% of her salary in the company 401(k) program. On top of that, the company agrees to match 50 cents for every dollar that the person contributes. So if the person contributes the full amount she’ll deposit $6000 into the account her company will match this by depositing an extra $3,000 bringing her total contribution up to $9000.

This contribution is tax-deductible meaning the person only has to pay income tax on $94,000 rather than  $100,000. She will only have to pay taxes when she withdraws the money from the account usually in retirement or after sixty when her tax bracket is lower. Matching is just one benefit plan another example could be profit sharing. Imagine that instead of the company matching fifty cents to the dollar they agree to contribute 1% of the company’s profits to the person’s 401(k).

Because of these benefits, the 401(k) is tool companies use for recruitment. If two identical companies offer the same salary but one offers 401(k) matching or profit-sharing then the person is probably going to choose the one which is offering 401(k). The 401(k) is also used as a tool for retention because of what’s also known as a vesting period. “Vesting” means the contributions are locked in for a specific period of time, for example, let’s say the person’s company tells her that their contribution takes 3 years to vest. This means that the person can’t withdraw the company’s  $3,000 for three years.

One more thing that you should know if the person quits or is fired from the insurance company, she is allowed to keep all of her contributions and all the company’s vested contributions. However, if she withdraws it as cash she has to pay taxes and a penalty. What she should do is roll over her contributions to another registered retirement account.

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