401(k)

Definition

A 401(k) is a type of retirement savings account that allows employees to contribute a portion of their paycheck on a pre-tax basis, deferring income taxes until withdrawal. It is a popular employer-sponsored retirement plan that provides tax-advantaged growth and withdrawal options for individuals to save and invest for their future retirement.

5 Must Know Facts For Your Next Test

1. 401(k) contributions are made on a pre-tax basis, reducing the employee's taxable income in the year the contributions are made.
2. Employers may offer matching contributions to employee 401(k) accounts, providing additional retirement savings incentive.
3. 401(k) accounts allow for tax-deferred growth, meaning the investments within the account can grow without being subject to annual taxation.
4. Withdrawals from a 401(k) account are taxed as ordinary income, unlike Roth IRA withdrawals which are tax-free in retirement.
5. Penalties may apply for early withdrawals from a 401(k) account before the age of 59 1/2, with some exceptions.

Review Questions

• Explain how the timing of cash flows is impacted by contributing to a 401(k) account.
  • Contributing to a 401(k) account affects the timing of cash flows in two key ways. First, the pre-tax contributions reduce the employee's taxable income in the current year, resulting in a smaller tax liability and more disposable income. Second, the investments within the 401(k) account grow tax-deferred, allowing for compounded growth over time. However, the tradeoff is that withdrawals from the 401(k) in retirement are taxed as ordinary income, whereas a Roth IRA would allow for tax-free withdrawals. The timing of these cash flows must be carefully considered as part of an individual's overall retirement planning strategy.
• Describe how employer matching contributions impact the value of a 401(k) account over time.
  • Employer matching contributions to a 401(k) account can significantly enhance the long-term value of the account. When an employer matches a portion of an employee's contributions, it effectively increases the employee's savings rate and accelerates the growth of the account balance through compounding. For example, if an employer matches 50% of an employee's contributions up to 6% of their salary, the employee's effective savings rate becomes 9% (6% employee contribution + 3% employer match). This employer-provided 'free money' can make a substantial difference in the account's final value at retirement, especially when considering the tax-deferred growth over many years.
• Analyze how the timing of 401(k) withdrawals in retirement can impact an individual's overall financial plan.
  • The timing of 401(k) withdrawals in retirement can have significant implications for an individual's overall financial plan. Since 401(k) distributions are taxed as ordinary income, withdrawing too much in a given year could push the individual into a higher tax bracket, reducing the net value of the withdrawal. Conversely, strategically timing 401(k) withdrawals to complement other sources of retirement income, such as Social Security or a Roth IRA, can help optimize the individual's tax liability and maximize the longevity of their retirement savings. Additionally, the required minimum distributions (RMDs) that begin at age 72 must be carefully factored into the withdrawal strategy to avoid penalties. Thoughtful planning around 401(k) withdrawal timing is crucial for achieving long-term financial goals in retirement.

Related terms

Contribution Limits: The maximum amount an individual can contribute to their 401(k) account each year, set by the Internal Revenue Service (IRS).

Vesting: The process by which an employee earns the right to access the full balance of their employer-contributed 401(k) funds, typically based on years of service.

Required Minimum Distributions (RMDs): The minimum amount that must be withdrawn from a 401(k) account each year, typically starting at age 72, to avoid penalties from the IRS.