The Basics of the 401(k)

April 01, 2022

Most often, the first question a prospective employee will ask is about your company’s benefit program. And in my experience, the two most often-asked questions are about health insurance and an employer-sponsored retirement program. Let’s examine the most common employer-sponsored retirement program that exists today – the 401(k) plan.

 401(k) plans were named for the section of the Internal Revenue Code in which they are described. They allow employees to contribute their own pre-tax money into a retirement account, often by way of automatic payroll deduction, which is a very powerful tool to help bring discipline to investing for retirement. By investing pre-tax dollars, employees are then able to lower their income taxes in the years they contribute to a 401(k).

In addition to lowering their current year income taxes, employees will not pay taxes on their 401(k) earnings until they withdraw them, usually at retirement.

Because contributions are made on a pre-tax basis, participants generally pay income taxes on their contributions when withdrawals are made – again, this is usually at retirement when they may be in a lower tax bracket. Withdrawals prior to age 59½ may be limited, and if available, may be subject to a 10% early withdrawal penalty. Withdrawals of after-tax contributions will not be taxed.

But is there a match?
The question that prospective employees really want to ask is this: does the company contribute to my personal 401(k) at all?

As an employer, you have the option to match some, or all, of your employee’s contributions – which further enhances the employee’s tax-deferred accumulations.

Additional Benefits
There are of course many other features that make 401(k) plans attractive. One example is the ability of plan participants (employees) to diversify their contributions in a variety of investment options offered under the plan. These investment options usually include a menu of mutual funds – equity funds, fixed-income funds, balanced funds, money market funds, etc. In addition, most plans allow employees to change how their assets are allocated among the various investment options, giving them the opportunity to create an individualized investment mix that is more in tune with their risk profile.