401 (K) | Meaning and Definition

What is a 401(k)?

A 401(k) implies a type of retirement savings account where the employers add funds on a pre-tax basis. It involves the deduction of money from a person’s pre-tax paycheck, which is then invested into different financial securities of an employee’s choice, such as bonds, mutual funds, etc. The money is set aside until the person’s retirement.

This plan is an optional scheme where the existing maximum contribution is either 23% of qualified income or $10,500, whichever is lower. If the funds are withdrawn from this tax-deferred retirement pension account before a person turns 59 and a half due to different serious reasons, a 10% penalty is levied.

Types of 401(k) plans

These plans can be categorized into two, namely, Traditional & Roth 401(k). Both types vary in how taxation is implemented. Let’s discuss.

–        Traditional 401 (k): The contributions are deducted from the pre-tax paychecks of traditional 401(k) employees. Instead of getting taxed as capital gains, the withdrawals are taxed as usual income. With this plan, account holders can lower their existing tax brackets.

–        Roth 410 (k): In the Roth, contributions are deducted from the paycheck after settling the taxes; however, one enjoys tax-free withdrawals. This is typically recommended for those who ween that they would slide into a higher tax bracket post-retirement than now.

This plan account balance is portable, which means you can take it if you change jobs. However, it is not recommended to cash it out when changing jobs, irrespective of how little the balance is. This is because doing so interrupts the flux of compound returns, and it is indeed challenging to compensate for the lost ground over the years. Rather, consider leaving there if the plan’s rewarding, or roll the account over to your latest employer.