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Investing 401k for dummies
Автор: Sahn | Category: Xmr cryptocurrency calculator | Октябрь 2, 2012
Before working as an editor, she earned a Master of Public Health degree in health services and worked in non-profit administration. A k plan is a retirement savings plan offered by many American employers that has tax advantages for the saver. It is named after a section of the U. The employee who signs up for a k agrees to have a percentage of each paycheck paid directly into an investment account.
The employer may match part or all of that contribution. The employee gets to choose among a number of investment options, usually mutual funds. Key Takeaways A k plan is a company-sponsored retirement account to which employees can contribute income, while employers may match contributions. There are two basic types of k s—traditional and Roth—which differ primarily in how they're taxed. With a traditional k , employee contributions are pre-tax, meaning they reduce taxable income, but withdrawals are taxed.
Employee contributions to Roth k s are made with after-tax income: There's no tax deduction in the contribution year, but withdrawals are tax-free. Among the benefits they offer is tax savings. There are two main options, each with distinct tax advantages. Traditional k With a traditional k , employee contributions are deducted from gross income , meaning the money comes from the employee's payroll before income taxes have been deducted.
As a result, the employee's taxable income is reduced by the total amount of contributions for the year and can be reported as a tax deduction for that tax year. No taxes are due on the money contributed or the investment earnings until the employee withdraws the money, usually in retirement.
Roth k With a Roth k , contributions are deducted from the employee's after-tax income, meaning contributions come from the employee's pay after income taxes have been deducted. As a result, there is no tax deduction in the year of the contribution. When the money is withdrawn during retirement, no additional taxes are due on the employee's contribution or the investment earnings.
However, not all employers offer the option of a Roth account. If the Roth is offered, the employee can pick one or the other or a mix of both, up to annual limits on their tax-deductible contributions. Contributing to a k Plan A k is a defined contribution plan. The employee and employer can make contributions to the account up to the dollar limits set by the Internal Revenue Service IRS. A defined contribution plan is an alternative to the traditional pension , known in IRS lingo as a defined-benefit plan.
With a pension, the employer is committed to providing a specific amount of money to the employee for life during retirement. In recent decades, k plans have become more common, and traditional pensions have become rare as employers shifted the responsibility and risk of saving for retirement to their employees. Employees also are responsible for choosing the specific investments within their k accounts from a selection their employer offers. Those offerings typically include an assortment of stock and bond mutual funds and target-date funds designed to reduce the risk of investment losses as the employee approaches retirement.
They may also include guaranteed investment contracts GICs issued by insurance companies and sometimes the employer's own stock. Contribution Limits The maximum amount that an employee or employer can contribute to a k plan is adjusted periodically to account for inflation , which is a metric that measures rising prices in an economy. If the employer also contributes or if the employee elects to make additional, non-deductible after-tax contributions to their traditional k account, there is a total employee-and-employer contribution amount for the year.
Employer Matching Employers who match their employee contributions use various formulas to calculate that match. For instance, an employer might match 50 cents for every dollar the employee contributes up to a certain percentage of salary. Financial advisors often recommend that employees contribute at least enough money to their k plans to get the full employer match.
Contributing to Both a Traditional and a Roth k If their employer offers both types of k plans, employees can split their contributions, putting some money into a traditional k and some into a Roth k. Employer contributions can only go into a traditional k account where they will be subject to tax upon withdrawal, not into a Roth. How Does a k Earn Money?
Your contributions to your k account are invested according to the choices you make from the selection your employer offers. As noted above, these options typically include an assortment of stock and bond mutual funds and target-date funds designed to reduce the risk of investment losses as you get closer to retirement.
How much money you contribute each year, whether or not your company matches your contribution, how your contributions are invested and the annual rate of return on those investments, and the number of years you have until retirement all contribute to how quickly and how much your money will grow.
And provided you don't remove funds from your account, you don't have to pay taxes on investment gains, interest, or dividends until you withdraw money from the account after retirement unless you have a Roth k , in which case you don't have to pay taxes on qualified withdrawals when you retire.
What's more, if you open a k when you are young, it has the potential to earn more money for you, thanks to the power of compounding. The benefit of compounding is that returns generated by savings can be reinvested back into the account and begin generating returns of their own. Over a period of many years, the compounded earnings on your k account can actually be larger than the contributions you have made to the account.
In this way, as you keep contributing to your k , it has the potential to grow into a sizable chunk of money over time. Taking Withdrawals From a k Once money goes into a k , it is difficult to withdraw it without paying taxes on the withdrawal amounts. When the traditional k owner makes withdrawals, that money which has never been taxed will be taxed as ordinary income.
Roth account owners have already paid income tax on the money they contributed to the plan and will owe no tax on their withdrawals as long as they satisfy certain requirements. Some employers allow employees to take out a loan against their contributions to a k plan.
The employee is essentially borrowing from themselves. Withdrawals are often referred to as distributions in IRS parlance. After age 72, account owners who have retired must withdraw at least a specified percentage from their k plans using IRS tables based on their life expectancy at the time. Note that distributions from a traditional k are taxable. Qualified withdrawals from a Roth k are not.
The employee must make contributions to it. The employer may choose to match some portion of that contribution or not. The investment earnings in a traditional k plan are not taxed until the employee withdraws that money. This typically happens after retirement when the account balance is entirely in the hands of the employee. More than million Americans are covered by defined-contribution plans, like a k or similar, nearly half of U. And nearly half of those plans are immediately vested participants in employer matching contributions, according to a report by Vanguard.
The Roth k Variation While not all employers offer it, the Roth k is an increasingly popular option. This version of the plan requires the employee to immediately pay income tax on the contributions. However, after retirement, the money can be withdrawn with no further taxes due on either the contributions or investment earnings. Employer contributions can only go into a traditional k account—not a Roth. Limits for High Earners For most people, the contribution limits on k s are high enough to allow for adequate levels of income deferral.
Employers also can provide non-qualified plans such as deferred compensation or executive bonus plans for these employees. The options are usually managed by a financial services advisory group such as The Vanguard Group or Fidelity Investments.
The employee can choose one or several funds to invest in. Most of the options are mutual funds , and they may include index funds , large-cap and small-cap funds, foreign funds, real estate funds, and bond funds. They usually range from aggressive growth funds to conservative income funds. Rules for Withdrawing Money The distribution rules for k plans differ from those that apply to individual retirement accounts IRAs. But while an IRA withdrawal doesn't require a rationale, a triggering event must be satisfied to receive a payout from a k plan.
The following are the usual triggering events: The employee retires from or leaves the job. The employee dies or is disabled. The employee experiences a specific hardship as defined under the plan. The plan is terminated. Post-Retirement Rules The IRS mandates k account owners to begin what it calls required minimum distributions RMDs at age 72 unless that employer still employs the person.
This differs from other types of retirement accounts. Money withdrawn from a k is usually taxed as ordinary income. This rollover allows them to escape the limited investment choices that are often present in k accounts. If you decide to do a rollover , make sure you do it right.
In a direct rollover , the money goes straight from the old account to the new account, and there are no tax implications. In an indirect rollover, the money is sent to you first, and you will owe the full income taxes on the balance in that tax year.
If your k plan has employer stock in it, you are eligible to take advantage of the net unrealized appreciation NUA rule and receive capital gains treatment on the earnings. That will lower your tax bill significantly. To avoid penalties and taxes, a rollover must take place within 60 days of withdrawing funds from the original account. The borrower must repay the loan within five years. A longer repayment period is allowed for a primary home purchase. In most cases, the interest paid will be less than the cost of paying real interest on a bank or consumer loan—and you will be paying it to yourself.
But be aware that any unpaid balance will be considered a distribution and taxed and penalized accordingly. Hardship Distributions There may come a time when emergencies arise. And you may find that the only place you can turn to meet your immediate financial needs is your retirement plan. While it may not necessarily be the best route, you have the option to take hardship distributions or withdrawals.
There are a number of considerations when it comes to this kind of withdrawal: There must be a clear and present need to take a hardship distribution. It can also be a voluntary or foreseeable need as long as it is reasonable. The amount of the withdrawal must not exceed the need.
You can't take any elective distributions for six months after the hardship withdrawal. This type of withdrawal is taxable. And if you take one of these, you aren't expected to pay it back to the account. Full details on hardship distributions are available through the IRS website.
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