What is a 401k?
Have you ever received a hefty chunk of change and immediately spent it all as if your pockets were made with swiss cheese lining, only to later see something you really need and wish you still had the money left to purchase it? It’s a pretty common problem. Money management is a noble ideal but a troublesome practice for many otherwise responsible working adults. A 401k plan helps to encourage a wage earning individual to set aside some his or her annual earnings for either retirement or a rainy day in the future, prolonging financial gratification for a later date at which you’ll be even more appreciative. A 401k plan is essentially a means of income deferral, opting to receive payment decades after it was actually learned, forcing the recipient to budget responsibly. In a traditional 401k plan, a percentage of wages are paid directly to the 401k account which is managed by the employer. The savings are in turn invested into one of a selection of funds (at the discretion of the employee) made available in the employer’s 401k plan. These payments are called “contributions.” Some companies will offer to match employee contributions with an additional company funded payment as an employee benefit, in part to encourage good saving habits and ensure long term financial flexibility for its workers.Under a traditional 401k, savings are accumulated on a pre-tax basis, with taxation deferred on the money saved until the time it is withdrawn (typically retirement). As of 2006, employees now have more flexibility on this front, as the Roth 401k plan was introduced, providing middle ground solution between the traditional 401k and the Roth IRA plan, which is tax free at the time of withdrawal. Under a Roth 401k, employees can choose to contribute their funds on a post-tax level, meaning no lump tax deduction upon withdrawal, in addition to or entirely in place of a pre-tax level, as seen in a traditional 401ks.