How 401 k Plans work

How 401 k Plans work – Explained by Your Bookkeeping Department

How 401 k Plans work – Tax season is well upon us. As we get closer to the April deadline, it’s becoming more apparent to people that reducing their taxable income can really make a difference in their financial situation. That’s why YBKD virtual bookkeepers thought to dedicate this month’s bookkeeping blog to explaining how 401 k plans work. For the most part, people know that 401 k plans are leveraged for retirement but don’t really know the ins and outs of the plans and how to take full advantage.

A 401 k is tax-advantaged, contribution retirement account

Let’s start first with the basics. A 401 k plan is offered by employers, allowing employees to contribute to their 401 k accounts through automatic payroll withholding’s. Employers can choose to match some or all of the contributions. In other words, different companies match different amounts, which come into play when companies recruit talent for their business. It’s part of the perks, just like healthcare benefits, vacations days and the like. The investment earnings aren’t taxed until the money is taken out of the account. The withdrawing is generally made after retirement.

Traditional 410 k and designated Roth account

There are two types of 401 k plans and they differ in the way they are taxed. One is called traditional 401 k plan, the other is called Roth 401 k plan which is basically tax-free. A Roth 401 k plan is funded with after-tax dollars up to the plan’s contribution. The biggest benefit is that because you’ve already paid taxes on your contribution, withdrawals in retirement are tax-free. With a traditional 401 k plan, you’ll pay taxes on your withdrawals based on the current tax rate at retirement. So if you think you’ll be at a higher tax bracket come retirement age, being a Roth account owner may be more advantageous to you.

Choosing your own investments

Part of explaining how 401 k plans work to mention that employees are tasked with choosing their investments, from their employer’s selection. These can include stock and bond mutual funds, target-date funds, guaranteed investments contracts issued by insurance companies and even employer’s own stock. It’s also worth noting that if an employer offers both traditional and Roth accounts, employees can split their contributions.

How much you can contribute

YBKD virtual bookkeepers, think it’s important for you to know that contribution maximums are adjusted regularly for inflation. In 2019, basic limits were at $19,000 a year for those under 50 years old. For those over that age, basic limits were at $25,000, including the $6,000 match-up contribution. When employers also contribute, those under 50 are capped at $56,000 or 100% of employee contribution; whichever is lower. For those over 50, that limit is at $62,000. In 2020, the virtual bookkeepers remind you that those numbers are going up a tad. Basic contribution is at $19,500, cap is at $57,000 and for those over 50 it’s at $63,500.

Employee/employer matching

Your Bookkeeping Department bookkeepers know that explaining 401 k plans mean to explain how much to contribute in these retirement plans. One popular way employers contribute to the match is that they offer 50 cents for every dollar an employee puts into their 401 k account. As far as employees, experts say workers should try to contribute at least enough to get a full employer match.

How 401 k Plans work – Taking your money out

To withdraw your funds from both traditional 401 k and Roth accounts, you have to be at least 59.5 years old or meet other requirements established by the IRS. This criteria can include disability. Otherwise you’ll pay a penalty for an additional 10% on top of any tax you owe. After 70.5 years old, account owners have to withdraw at least a specified percentage from their 401 k plans, using IRS tables based on life expectancy. If you’re still working and account is with current employer, you may not have to take withdrawals.