Understanding 401K

Understanding a 401(k) Plan Why You Need to Start Saving For Retirement Today

by David Presson (Murray State '77), contributing writer

A401(k) plan is a tax-advantaged, defined-contribution retirement account offered by many employers to their employees. It is named after a section of the U.S. Internal Revenue Code. Workers can make contributions to their 401(k) accounts through automatic payroll withholding, and their employers can match some or all of those contributions. The investment earnings in a traditional 401(k) plan are not taxed until the employee withdraws that money, typically during retirement.

Taxes can take a big bite out of your total investment returns and having a 401(k) plan offers a variety of tax benefits. When you contribute to a traditional 401(k) plan, your contributions are deducted from your pay before income taxes are assessed. The pretax contributions reduce your current taxable income, which in turn reduces the amount of taxes owed each year. The other tax benefit of a plan is the tax-deferral of your yearly returns. In a taxable account, you are obligated to pay taxes on the income each year as well as any capital gains from investments sold, in addition to capital gain distributions from mutual funds. The taxes on these returns will dilute your returns over time and, in some cases, in a meaningful way if you are not careful. However, in a 401(k) plan, you can delay paying the taxes on your gains until you withdraw the money during retirement. While you are not completely avoiding the taxes, the delaying process can enable your yearly returns to compound at a much higher rate than if you had to pay the taxes each year. In addition, depending on your situation, when you are in retirement you could be in a lower marginal tax bracket than in your peak earnings years. Given the tax benefits, it makes sense to try to contribute as much as you can afford each year to your plan. Individuals can contribute up to $19,500 in 2020 vs. $19,000 for 2019. For those people 50 years or older, the IRS allows a larger amount. For 2020, this amount is $26,000 per individual vs. $25,000 in 2019. Even if you can’t contribute the maximum amount each year, be sure to contribute what you can. Through the yearly power of compounding, even small amounts have the potential to add up over time. Your employer may also contribute to your

plan through matching or profit-sharing contributions. If your employer offers a match, be sure you’re contributing enough to get the full benefit of this match. For example, if your employer matches the first 5% of your contributions, make sure you contribute at least 5% each year to get his full benefit; think of it as free money! Some other things to consider with your 401(k) plan:

• If you take money out of your plan before the age of 59 ½, in addition to the normal taxes owed on the distribution, you could also be subject to a 10% early distribution penalty. • However, depending on your plan’s provisions, you may be able to make a hardship withdrawal for certain types of financial needs such as covering a medical or burial expense, or avoiding a foreclosure on a home. These withdrawals would still be taxable, but not subject to the extra 10% penalty.

• In some cases, depending on your plan’s provisions, you might be able to borrow against your 401(k) balance. The proceeds from the loan would not be taxable. • Finally, one other benefit of the 401(k) plan is that generally your assets are fully protected from your creditors in the event of a lawsuit or bankruptcy.

So, in summary, there are many benefits to investing in your employer’s 401(k) plan, so make sure you’re taking advantage of them as much as possible.

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