401(k) advantages: Everything you need to know

LAST REVIEWED Jan 16 2021 9 MIN READ

By The Human Interest Team

If you’re trying to save money for retirement, it’s a good idea to enroll in a 401(k) plan. This type of retirement plan offers many advantages over a regular savings account — from tax benefits to employer matching contributions. Below is a comprehensive explanation of a 401(k) plan and its advantages.

What Is a 401(k) Plan?

The more you understand your 401(k) plan, the more you’ll know how it fits into your investments and the better you’ll be able to adjust it to suit your financial goals over time. Named after an Internal Revenue Code section, a 401(k) plan refers to a contribution plan that an employer sponsors as a vehicle for retirement investment. It’s a tax-favored retirement plan, and it’s mostly offered through employers.

If your employer has a 401(k) plan, you can voluntarily opt to contribute a certain portion of your salary to the plan. Such a contribution is automatically deducted from your paycheck as pretax income. In an employer-match 401(k) plan, your employer may match some of the funds you deposit into your account. Some companies offer 50% of the first 6% or less you contribute to your 401(k) account. 

For example, let’s say you earn a salary of $45,000. If you choose to contribute 6% of your income, which is $2,700, your employer may contribute 50% of that amount, which is $1,350. Some employers even match their employees’ contributions dollar-for-dollar.

The IRS imposes a limit on the amount you can contribute to your 401(k) account each year, which is $19,500 in 2020 and 2021. If you’re 50 or older and expect to reach this elective deferral limit, you can opt to contribute an additional $6,500, bringing the total to $26,000. This additional contribution is referred to as a catch-up contribution.

Benefits of a 401(k) Plan

A 401(k) plan offers many benefits to help you work towards a financially secure retirement. Below is a list of reasons why you should consider starting a 401(k) account:

Tax Benefits

Tax benefits are one of the most attractive 401(k) advantages. These benefits begin with the fact that you make regular contributions to your account on a pretax basis. This means you don’t have to pay federal income tax for contributions up to the $19,500 or $26,000 limit, which lowers your taxable income.

Also, earnings accumulate in your 401(k) account on a tax-deferred basis. As such, your dividends and capital gains aren’t subject to tax until you start making withdrawals. If you don’t withdraw any funds until you retire, you’ll most likely pay less in tax than you would at the time you made the contributions. In most cases, people earn less after they retire, which puts them in a lower tax bracket.

Employer Matching Contributions

Some employers match their employees’ 401(k) contributions, while others offer a profit-sharing feature that contributes a certain portion of their profits to their employees’ 401(k) accounts. If your employer offers any of these features, it’s a good idea to sign up for them because they essentially mean you’re receiving free money. As for the annual contribution limit of $19,500, it only applies to your personal contributions. Employer contributions don’t count toward the limit.

Continued Contributions for Employed Participants

If you have a traditional IRA or some other retirement account, you aren’t allowed to contribute after you reach 70 1/2 years old even if you’re still employed. Therefore, you have to pay taxes on the money you’ve contributed on a pre-tax basis at your current tax rate, which is typically higher than the rate that applies to you after retirement.

With a 401(k) plan, you can continue to make contributions as long as you’re still employed. Additionally, you aren’t required to take mandatory distributions from your plan while you’re employed if you don’t own 5% or more of the company that employs you.

Protection Against Creditors

If you happen to run into debt trouble, it’s a good idea to keep your money in places that are inaccessible to your creditors. A 401(k) plan provides protection against creditors. Accounts established under the Employee Retirement Income Security Act (ERISA) are typically protected against judgment creditors, and the 401(k) plan is one of them.

401(k) plans usually provide some protection against federal tax liens, which are claims the government files against the assets of taxpayers with unpaid back taxes. Since your employer is the legal owner of your 401(k) plan, it’s harder for the IRS to impose a tax lien on your account.

Post-Tax Contributions

Besides making tax-deductible contributions to a 401(k) plan, you’re also allowed to make post-tax contributions through a Roth 401(k). Human Interest allows a Roth 401(k) option.

Using the Roth option gives you more savings possibilities, but not all providers, including Human Interest, offer one of those possibilities (a “mega backdoor” Roth).

The government allows a maximum of $57,000 in employee and employer contributions to your 401(k) account every year if you’re a younger worker and $63,500 if you’re 50 or older. Assuming you’ve maxed out your tax-favored contributions, you can make a maximum of $38,500 in post-tax contributions to your account, depending on whether and how much your employer matches. If your employer allows it, you can transfer this post-tax money to a Roth IRA so that you can withdraw future gains tax-free.

Post-tax contributions also allow you to build non-retirement savings. For example, Prudential introduced a feature to enable workers to make automatic post-tax contributions to their 401(k) accounts that they can use to build emergency savings. These funds are available whenever needed, meaning you can withdraw the principal amount without incurring taxes or penalties.

Potentially Easier and More Affordable Investment Options

As a participant in a retirement plan, you’ll likely have the option to purchase “institutional” shares of mutual funds. These shares are generally more affordable than retail shares. In addition, having a 401(k) account makes investing simpler. Many plans come with fully diversified “one-stop-shop” features such as target-date funds and balanced funds. A target-date fund automatically becomes more conservative as your target retirement date gets closer, so you don’t have to do anything after you set it.

If you want to know more about 401(k) plan benefits, don’t hesitate to get in touch with the knowledgeable and helpful team at Human Interest.

We believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment advising, and integration with leading payroll providers.

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