A 401k plan is a tax-deferred retirement saving and investing program employers offer. These plans significantly benefit participants, including tax breaks and access to investment professionals.
However, they can also be confusing and complicated, especially for those who don’t have experience in the industry. That’s why it’s essential to understand what these plans mean for you and your employees.
401k plans allow employees to save money tax-deferred until they withdraw it in retirement. The accounts are also popular with business owners who still need employees.
Employees have various investment options within their 401k plans, which can impact how quickly savings grow and how much risk is involved. They can also choose to have the plan automatically rebalance their investments based on their goals and risk tolerance.
Because earnings are not taxed until withdrawn, they can offer investors a valuable advantage over other investments. They can buy and sell stocks, mutual funds, real estate, and other assets without worrying about triggering a capital gain tax.
401k plans are one of the most popular options for small businesses because they offer flexible benefits. Providing these benefits helps employers attract and retain top talent and encourages employees to save for retirement.
The flexibility a 401k plan provides allows you to meet employees’ needs, including changing contributions, investment options, and withdrawal options. It also allows you to take advantage of tax credits and other incentives for starting a 401k plan, which may reduce your overall costs.
The flexibility of a profit-sharing plan enables business owners to allocate a portion of their contribution rate to high performers or other highly compensated employees. This allows employers to reward their top talent and keep workers focused on building a company.
Most 401k plans allow you to invest in mutual funds, index funds, or exchange-traded funds (ETFs). You can choose from actively managed and passively managed funds.
While investing in a 401k plan can be an excellent way to save for retirement, picking investments that suit your risk tolerance and investment objectives is essential. That means spreading your money across various asset classes — stocks, bonds, and others.
Ideally, you should take a more aggressive approach early on to capture returns and gradually dial it down as you get closer to retirement. A target-date fund helps you choose a portfolio with a specific calendar year allocation most relative to your desired retirement date.
Loan or hardship withdrawal options
If you need extra money to deal with a financial emergency, your 401k plan may offer loan or hardship withdrawal options. These withdrawals are helpful to get you through tough times, but they should be used carefully to avoid tax penalties and ensure you can keep up with your retirement savings goals.
If your 401k offers loans, the interest rates are generally much lower than other forms of borrowing, and repayment is usually a quick process. But a loan also depletes your 401k account, diminishing your potential for tax-deferred growth.
If you’re unsure whether to borrow from your 401k or take out a hardship withdrawal, talk to a financial planner before making any decisions. They can help you determine the best action and the short-term and long-term financial implications.
Required minimum distributions
After decades of putting away money in tax-advantaged retirement accounts, many savers turn 72 and have to start taking out their savings, known as required minimum distributions (RMDs). These withdrawals raise income taxes and prevent people from using their retirement accounts as tax shelters.
RMDs apply to 401k plans, IRAs, and other retirement accounts. The IRS enforces these rules to discourage people from taking advantage of these accounts’ tax deferral benefits and avoid paying taxes on their retirement account balances.
RMDs are calculated by dividing your year-end balance by an IRS life expectancy factor based on your age and account value at the time of your withdrawal. Generally, you must begin taking your RMDs by April 1, following the year you reach age 72.