A 401(k) is a retirement savings and investing plan that many employers offer. Certain types of 401(k) plans offer employees a tax break on money they contribute. Contributions to a Traditional 401(k), one type of 401(k), are automatically withdrawn from an employee paycheck, and invested. The amount you choose to contribute to your traditional 401(k) is deducted from your paycheck before taxes are taken out. As a result, you’re paying taxes on a smaller portion of your salary and your overall tax rate may be lower.
A Roth 401(k), another type of 401(k), is made with after-tax dollars, so although you may pay more in taxes up front, the payoff could come after you retire.
Many employers offer to match a portion of what you contribute to your 401(k). That means they will match the dollars you contribute to your 401(k), up to a certain amount. Be aware of your plan's vesting schedule – that’s the time you're required to be at the company before you're allowed to walk away with 100% of your employer matches.
While your money is in your 401(k), it’s protected from taxation. This is true for both traditional and Roth 401(k)s. As long as the money remains in the account, you pay no taxes on investment growth, interest, dividends or gains.
You own the money you contribute to your 401(k) – so if you change employers, you can roll it over into your new employer’s 401(k) or another qualifying retirement plan account. Once you’ve put dollars in, however, there are penalties if you decide to take them out before you reach retirement age.
After you retire and start making withdrawals from your account, that’s when you will pay income tax on monies saved in a Traditional 401(k) plan. The good news is that your tax rate may be lower in retirement, so you could end up paying less in the end.
If you have a Roth 401(k), you will not owe the IRS tax when you start taking distributions from these funds, as you made your contributions with after-tax dollars.
Please Note: There are several types of 401(k) plans and not all employers offer all of them, nor are they all ‘created equal.’ In order to ensure you’re getting the most benefit from your employer’s 401(k) and the type of investments offered, contact Blackhawk Wealth Advisors for a 401(k) review.
Sources: nerdwallet.com; securianfinancial.com; cnnmoney.com