How Exactly Does The 401(k) Work?
When the congress decided that the American people needed a little push to start working on their retirement savings, they passed the Tax Reform Act. Part of this Act was the creation of a tax deferred plan for saving. The reason that it is called 401(k) is because the plan was stated in section 401 paragraph k, in the Internal Revenue Code. It is recommended that you hire a good accountant to get advice on your unique financial situation.
Some of the basic advantages that the plan offers are:
Less taxable income, not having to worry about money when you retire, and saving accumulate directly from your income. These are just one of the few reasons why the 401(k) became popular among employees.
Although retirement plan are the last thing that someone should be worried about it, think about how much of that plan will stack up in a decade.
The key things about the 401 (k) are:
- When you participate in this plan you get to tell your employer how much money you can put into the account. You can even put up to 15 % of your income into the account if you want.
- The money that you plan on contributing comes out from your pre- tax income. This is one burden free way to save for retirement.
- You employer can also match a portion of your contribution; this is a way to motivate you to participate in the plan because if you do not then it makes it difficult for them to comply with certain regulations.
- The money that you contribute is passed on to be invested in money market accounts, funds, bonds etc.
The only drawback is that if you plan on withdrawing this money before you are 59 and half years old, you get penalized on top of paying a tax on it.
Why The 401 (k) Overrules Other Options
Now why would it be better for you to contribute to a 401 (k) plan then it would be to invest in stocks for example? And you will not even be penalized for selling these. The reason why you should opt in opposite is because the 401 (k) plan makes sure that the money that you contribute is taxed and that your employer is matching all these with company money.
There are certain 401 (k) plans that let you borrow the money if you are faced with an emergency. If you are thinking about opening an IRA you can take note that you are only allowed to contribute up to $4000 a year, to an IRA. Now on the other hand your contribution to the 401 (k) can go up to $11000.
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Originally published at freedomtaxaccounting.com.