401(k)

Definition

A 401(k) is a type of retirement savings account that allows employees to contribute a portion of their paycheck, on a pre-tax or after-tax basis, to an individual investment account. Employers may also contribute to these accounts, providing a valuable employee benefit.

5 Must Know Facts For Your Next Test

1. 401(k) plans allow employees to save and invest a portion of their paycheck before taxes are taken out, deferring income taxes until retirement.
2. Contributions to a 401(k) plan are limited annually by the IRS, with the limit for 2023 being $22,500 for individuals aged 50 and over.
3. Employers may offer a 401(k) match, where they contribute a certain percentage of an employee's contributions, up to a specified limit.
4. 401(k) accounts typically have a vesting schedule, meaning employees must work for the company for a certain period before they can fully own the employer's contributions.
5. Early withdrawals from a 401(k) plan before age 59 1/2 may be subject to a 10% penalty, with some exceptions such as disability, financial hardship, or leaving the company.

Review Questions

• Explain how a 401(k) plan can benefit employees in terms of saving for retirement.
  • A 401(k) plan allows employees to save for retirement by contributing a portion of their pre-tax salary into an individual investment account. This provides several benefits, including the ability to defer income taxes on the contributions until retirement, potential employer matching contributions, and the opportunity for tax-deferred growth of the investments within the account. By starting to save early and taking advantage of the long-term compounding of investments, employees can build a substantial retirement nest egg through a 401(k) plan.
• Describe the role of vesting in a 401(k) plan and how it impacts employee benefits.
  • Vesting in a 401(k) plan refers to the process by which an employee earns the right to access the full balance of their account, including any employer contributions. Vesting schedules typically range from immediate vesting to a multi-year vesting period, during which the employee gradually earns a larger percentage of the employer's contributions. This vesting schedule can incentivize employees to remain with the company for a certain period, as they will forfeit a portion of the employer's contributions if they leave before becoming fully vested. The vesting schedule is an important factor for employees to consider when evaluating the overall value of a 401(k) plan as part of their compensation and benefits package.
• Analyze the potential drawbacks and penalties associated with early withdrawals from a 401(k) plan and how they may impact an individual's retirement savings.
  • While 401(k) plans provide valuable tax-advantaged retirement savings, there are potential drawbacks and penalties associated with early withdrawals. Typically, withdrawals made before the account holder reaches the age of 59 1/2 may be subject to a 10% penalty, in addition to regular income taxes on the withdrawn amount. These penalties are designed to discourage early access to retirement savings and encourage long-term investment. Early withdrawals can significantly erode an individual's retirement nest egg, as the withdrawn funds miss out on the potential for long-term growth and compounding. Furthermore, the loss of tax-deferred growth on those withdrawn funds can have a substantial impact on the individual's overall retirement savings. Careful consideration of the penalties and long-term consequences is crucial when evaluating the decision to make an early 401(k) withdrawal.

Related terms

Employer Matching: The practice where an employer contributes a certain amount to an employee's 401(k) account, typically based on a percentage of the employee's own contributions.

Vesting: The process by which an employee earns the right to access the full balance of their 401(k) account, including any employer contributions, over a specified period of time.

Withdrawal Penalties: The fees or taxes that may be imposed on 401(k) withdrawals made before the account holder reaches the age of 59 1/2, with some exceptions.