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401k


A 401(k) is a type of retirement savings plan offered by many employers in the United States. It allows employees to contribute a portion of their pre-tax income into an investment account, where it can grow tax-deferred until retirement. The name "401(k)" comes from the section of the Internal Revenue Code that governs these plans.


Differences Between Roth 401(k) and Traditional 401(k):


Tax Treatment:

  • Traditional 401(k): Contributions are made with pre-tax dollars, reducing taxable income in the year of contribution. Withdrawals in retirement are taxed as ordinary income. Roth 401(k): Contributions are made with after-tax dollars, so they don't reduce taxable income in the year of contribution. However, qualified withdrawals, including both contributions and earnings, are tax-free in retirement.

Withdrawal Rules:

  • Traditional 401(k): Withdrawals are subject to income tax and, if taken before age 59½, may incur a 10% early withdrawal penalty (with certain exceptions). Roth 401(k): Contributions can be withdrawn tax-free at any time, and qualified withdrawals of earnings are also tax-free after age 59½, provided the account has been open for at least five years.

Employer Match:

  • Both types of 401(k) plans can potentially include employer matches, where the employer contributes funds to the employee's retirement account based on the employee's contributions.

Pros and Cons:


Traditional 401(k):

Pros:

  • Immediate tax savings, as contributions are made with pre-tax dollars. Lower taxable income in the present, potentially reducing current tax burden. Ideal for individuals who expect to be in a lower tax bracket during retirement.

Cons:

  • Withdrawals are taxed as ordinary income in retirement. Limited flexibility in managing tax liability during retirement.

Roth 401(k):

Pros:

  • Tax-free withdrawals in retirement, providing tax diversification. Ideal for individuals who expect to be in a higher tax bracket during retirement. Flexibility in managing tax liability in retirement.

Cons:

  • Contributions are made with after-tax dollars, reducing immediate take-home pay. Limited to those who meet income eligibility requirements.

Employer Match Example:

Let's consider an example of how employer match works:

Allegra works for a company that offers a 401(k) plan with an employer match. The company offers a dollar-for-dollar match on up to 5% of her salary. Sarah earns $50,000 per year.


Allegra's Contribution: Allegra decides to contribute 5% of her salary to her 401(k), which amounts to $2,500 per year ($50,000 x 5%).


Employer Match: Since the company offers a dollar-for-dollar match on up to 5% of her salary, they will also contribute $2,500 per year to Allegra's 401(k).


Total Contribution: With the employer match, Allegra's total annual contribution to her 401(k) is $5,000 ($2,500 from her and $2,500 from her employer).


Impact on Savings: By taking advantage of the employer match, Allegra effectively doubles her retirement savings without any additional effort. This boost can significantly accelerate her retirement savings growth over time.


In this example, the employer match acts as an incentive for Allegra to contribute to her 401(k), helping her save more effectively for retirement.



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