401(k) plans allow employees to invest a portion of their paycheck before payroll taxes are deducted. Those funds are taxed only upon withdrawal, which should only happen after you retire. 401(k)s allow funds to grow tax-free until they're withdrawn, and the plans are especially smart if you expect to be in a lower tax bracket upon retirement than you are currently.
The IRS imposes a limit on annual 401(k) contributions. For 2016, they are capped at $18,000 per year for people under 50, and $24,000 for people 50 and above.
Many plans include an matching-funds component, where employers contribute money alongside employees, sometimes as much as 100%, thereby doubling an employee's investment immediately. Returns of 100% are very hard to get with any investment! While the actual funds available in 401(k)s are usually limited and poor, the tax benefits and employer-matching funds more than compensate for that.
Keep In Mind:
Note that employer contributions sometimes have vesting schedules to promote employee retention; that is, more matching funds become yours the longer you stay with the company. Employee contributions, of course, "vest" immediately.
Employees can choose among various investment funds in their 401(k) plans, usually from a limited range of options. The plans often include pre-packaged investments like target date funds, which shift your asset allocation over time. Many mutual funds included in 401(k)s plans have high hidden fees, so make sure you can measure the total cost of the plan, not just the fees they disclose in large print.
When you leave a job, you can roll over your 401(k) account to an IRA or a Roth IRA. This is usually wise, considering the limited options and high fees imposed by many plans.
Here's what you need to know about 401(k)s in one table:
|Eligibility||Eligibility depends on employer, as 401(k)s are employer-provided defined-contribution plans|
|Contribution Limits (2016)||- Age <50: $18,000 per year |
- Age 50-65: $18,000 per year + a $6,000 catch-up provision per year
|Taxes||- Paycheck contributions may be made either pre or post tax |
- Earnings are tax deferred until withdrawals/distributions
|Employer Match||Employers often match a pre-selected percentage of each employee's individual 401(k) contribution|
|Investment Selection||Investment selection may be limited and often includes pre-packed products such as target date funds. Consideration of expense ratios and underlying costs is important|