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What Is An Individual 401k Plan? 401k Limits, Rules, and Benefits Explained

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35.3K

There are so many retirement plans to choose from when planning for retirement. We have previously covered the Roth 401k plan, the traditional IRA, the Roth IRA fund, and all of the advantages and disadvantages of each of these options. The plan that I want to cover today is probably the one you’ve heard about the most and the one that gets the most media attention: the traditional 401k plan.

Let’s take a look at some of the key features of a traditional 401k plan:

Tax Deduction

401k plans are the most popular employer-sponsored defined contribution plans available today. Every contribution that an employee makes to the plan entitles an employee to a tax deduction. 401k contributions that are taken directly from your paycheck are free from income taxes. Taxes are not paid until you take a withdrawal from your account.

As an example, let’s say you contributed $10,000 to your 401k plan during the year. Based on the current rules, your taxable income would be lowered by $10,000 for the current year. You would not have to pay taxes on the funds until you take a withdrawal from your account. This allows you to contribute more to your plan and lower your taxes.

401k plans require that plan participants take a withdrawal by the age of 70 ½. Plan participants must begin withdrawing money by April 1st of the year after you turn 70½. This amount is known as the required minimum distribution (RMD). An account owner who fails to take out the required minimum distribution will find their account subject to an IRS penalty. This requirement is one way for the government to guarantee that it will receive taxes on your money at some point.

The 401k tax feature is the exact opposite of the tax features of the Roth IRA and the Roth 401k plan. With these accounts, while the contributions to the fund are not tax deductible, any withdrawals (including any capital gains), can be taken out of the account tax-free upon retirement.

employer and employee shaking hands

Employer & Employee Matching Program

The biggest advantage of a 401k is the employer match. An employer match is free money that your employer is contributing to your account. Most employers will match employee contributions dollar for dollar up to a certain percentage.

Again, as discussed in the prior section, the tax deferral benefit allows employees to postpone taxes until much later in the future. Plan participants should aim to schedule withdrawals so that they are paying lower taxes in the future than they would today.

Maximum Contribution

The current maximum 401k contribution limit is $16,500 for adults that are under the age of 50. Adults that are 50 and over can contribute an additional $5,500 due to catch-up provisions.

Highly compensated workers may not be eligible to fully contribute to their company’s 401k. An individual is considered a highly compensated employee if he or she currently makes over $110,000 per year or owns more than a 5% interest in the employer’s business.

How To Participate In A 401k

You can only participate in a 401k plan if your employer offers the plan. These plans are a hit with employees because of the tax savings and the matching contributions.

401k plans are a great way to put your retirement saving on cruise control. Having your contributions directly deducted from your paycheck takes the burden off of your shoulders. You can also structure your 401k to split your contributions between money market funds, stock funds, bond funds, and company stock. Check with your employer to see what funds your 401k offers.

young people discussing

Final Word

The traditional 401k plan is as popular and widespread as it is because it has some truly unique benefits and can be crucial to someone’s retirement.  However, don’t forget that there are other options out there that you can use in place of or in conjunction with your 401k plan: Roth 401k, Roth IRA, Traditional IRA. Each plan has something to offer you. Depending on your personal financial situation, you need to choose the best plan for you.

Are you a fan of 401k’s? Do you fully participate in your company’s plan?

(Photo credit: MJTR)

Mark Riddix
Mark Riddix is the founder and president of an independent investment advisory firm that provides personalized investing and asset management consulting. Mark has written financial columns for Baltimore and Washington, D.C. area newspapers and is the author of the book, "Your Financial Playbook."

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