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Introduction to 401(k) Plans

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What is a 401(k) Plan and How Does it Work?

As employees get closer to retirement, it’s important for them to know they have savings to live on. Chances are they’ve started saving at a younger age in one of the many investment accounts available to them. One of the easiest ways for an employee to save is through their employer’s 401(k) plan.

A 401(k) plan is a defined contribution retirement plan. The IRS passed legislation in the 1980s to help individuals save for retirement through the help of their employers. 401(k) plans only really started to take off in the 1990s, and with the disappearance of pension plans, they’ve become one of the major retirement savings tools.

401(k) plans are limited to private for-profit non-government companies. Any company can set up this plan for their employees. Even if you are self-employed, you can still set up, though it may be cost prohibitive. Those that are self-employed or who run a small business may opt to take advantage of a Solo-401(k) or Individual(k) plan.

Under a 401(k) plan, an employee sets aside a percentage of their salary through payroll deductions and the money is deducted on a regular schedule. There are two ways to invest the money:

  • It can be invested in an account set up through a third party administrator, who invests in a mix of stocks, bonds, mutual funds and money market accounts.
  • It is allocated to a trustee, who then decides how to invest it.

There is a limit to how much each person can contribute to their 401(k) plan. The IRS contribution pre-tax limit for the year of 2008 is $15,500. There is an exception for anyone age 50 or older. Those that fall in this age bracket can invest up to a maximum of $20,500 (an additional $5,000) on a pre-tax basis.

Why Use a 401(k) Plan?

Employees benefit from these accounts in a couple of different ways.

The reason a 401(k) is such a widely used plan for retirement is because of its pre-tax benefits. Any money invested into the plan is not taxed; instead this money accumulates interest tax-free. The initial investment and interest are only taxed upon withdrawal. In other words, this is a tax-deferred account.

Investing money into a 401(k) plan also ensures that the account holder has savings at the age of retirement. Since money is taken directly out of the paycheck, it’s an easy way to know they’ll be taken care of without thinking about contributing to a separate account.

Administrative costs for managing a 401(k) can be high, especially if you’re running a small business. Consider a matching program that lets your company contribute funds after a certain number of years. Many smaller companies have a program where they match 0% of their total matching funds the first year, 20% of their matched funds the second year, and so on. A system like this is beneficial for employees who plan to stick around and help grow the business over the long term.

If you own a small business and can’t afford to put match money in a 401(k) plan, it’s still valuable to you and employees to set up this retirement contribution account. You may not be able to match funds, but that doesn’t mean employees won’t contribute. The tax savings are still plentiful and make a 401(k) account worthwhile. And while your employees won’t receive additional matching money, they’ll still end up saving money on taxes in the short term, and for retirement in the long term.

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