Savings Tax Breaks for Middle America – 401(k) Plans
This post is an excerpt from The FinancialVerse – A Common Sense Approach for Your Money that was released on October 9th.
The second of the Big Four tax breaks for Middle America is the 401(k) plan. I have found that many people are unaware of their employer’s plan and are not taking advantage of the tax and contribution incentives offered. Here is what this plan is all about and how it can help you save for your later years.
A 401(k) is a federally designated retirement savings plan sponsored by an employer. It allows workers to save and invest a portion (up to a maximum of 100 percent of their salaries with a cap of $19,000 for 2019) of their pay on a pre-tax basis. The money put into the plan is not company money but yours subject to certain restrictions. You do not need to worry that your employer can take your funds.
Federal and state income taxes aren’t paid on the money deposited into the 401(k) plan until the money is withdrawn from the account. It is assumed you will be in a lower tax bracket once you start withdrawing the funds.
The key aspect with a 401(k) plan is that you direct and control how your money is invested. Most plans offer a wide range of investment options you can select for your money. These investments usually include money market funds, certificates of deposit, all types of mutual funds, and exchange-traded funds (ETFs).
To give you the benefit of not paying income taxes on the funds until withdrawal, the federal government, through the Internal Revenue Service (IRS), has put restrictions on what you can do with your 401(k). For instance, in most cases, you can’t tap into your employer’s contributions immediately. Vesting of employer contributions is the amount of time you must work for your company before gaining access to its payments to your 401(k). Your payments, on the other hand, are always yours and vest. The fact that you can’t immediately access your employer’s contribution to your 401(k) is insurance against employees leaving early. On top of that, there are complex rules about when you can withdraw your money and costly penalties for pulling funds out before age fifty-nine and one-half.
To oversee your account, your employer usually hires an administrator like Fidelity Investments or Charles Schwab. They’ll email you updates about your plan and its performance, manage the paperwork, and assist you with requests. If you want to keep watch over your account or shift your money around, go to your administrator’s website or call their help center.
As part of making your savings hit the 10 to 15 percent target, most financial experts say people need to fund their later years, once you are in a favorable cash position you should put as much as possible into the 401(k) plan to obtain the maximum employer matching contribution. Be mindful that you’ll need to have enough money to pay your basic living expenses and create your emergency fund before you begin your 401(k) plan. At the very least, you should contribute enough to get the full matching amount that your company pays. You don’t want to leave free cash on the table. Nearly every plan offers matching funds—the average being 4.7% for 2018 according to Fidelity Investments.
So how does a 4.7 percent employer match work? If you put in 4.7% percent of your $50,000 salary, or $2,350, your company puts in another $2,350 to match your contribution. For a company offering a 4.7 percent match, you can usually add more than that $2,350 yourself, but the company won’t match beyond 4.7 percent. Many employees will add additional amounts to their plans based on getting raises or bonuses during a year. The rules for matching funds vary, so be sure to check with your employer about qualifying for its contributions.
The IRS sets maximum contribution limits for 401(k) accounts. These limits change each year. For 2019, the most you can put into your fund is $19,000 in any combination of pre- and after-tax dollars. If you’re age fifty or older, you can add another $6,000 (this is to allow older individuals to make up for lost time and increase their retirement savings).
If your company offers a 401(k) plan, please read all the information before joining. Knowing the details of your company’s plan will allow you to take maximum advantage of all the benefits the plan has to offer.