What is a 401K? Here is the legal and technical answer: in the United States, a 401k plan is an employer-sponsored contribution pension account defined in subsection 401k of the Internal Revenue Code.
A bit confused?
Let me break it down further in plain English.
A 401k is a pension account. A pension is any plan or fund which provides retirement income. So a 401k is dedicated to helping you save for retirement.
Now that you know what a 401k is, you might still be wondering why you should use it and how to set one up.
I have answers to both questions.
Why should you have a 401k?
A 401k is used to defer income today to save for tomorrow. In order to set up this type of account, you need to be employed and your employer needs to have a 401k plan that it offers to its employees.
The U.S. government enables employees to make tax-deferred contributions to their retirement account every year. As of calendar year 2021, the annual contribution limit for an employee under the age of 50 is $19,500.
So this means that, if you're under 50 years old, the most you can contribute to your 401K plan is $19,500 a year.
You might be wondering why the IRS limits annual contributions. There are two reasons:
- The IRS wants to prevent highly paid workers from benefitting more than the average worker from the tax advantages they provide.
- The government wants people to spend some of their income today.
IRA Contribution Limit for 2020 (and every year back to 2002)
Here is a table showing historical limits. As you can see, each year the total contribution limit goes up slightly to account for inflation and increases wages.
A note about this table: as an employee, you are not able to contribute more than $19,500 of your annual salary to your 401k if you are under 50 years old. If you are older than 50, however, the government enables you to make larger savings contributions.
This policy is intended to accelerate savings from people closer to retirement age.
Employers could contribute up to $57,000 (catch-up at $63,500) in 2020; in 2021 that amount has risen to $58,000 (or $64,500 with the catch-up contribution).
Why you should contribute to a 401k
If you are researching 401k contribution limits, perhaps you already understand the benefits of this savings account. If not, let me outline three reasons why a 401k can help you plan for retirement.
You can leverage these points if you are looking for finance feedback or if you're becoming better informed about how to plan for retirement.
- It is easy and painless. Money can be deducted from your paycheck in regular intervals. No need to engage in manual saving.
- Many firms offer some sort of employer match as a financial incentive to save. Matching is a perk, like leadership development or office food. It is provided at the discretion of the firm and can be retracted. So if you take advantage of matching you will obtain even greater funds.
- Tax breaks and benefits: your paycheck contributions are tax deductible. Because the capital you contribute doesn’t count towards your gross income, your net tax bill is lowered. Secondly, the money that is saved is tax-deferred. Over the course of your career these deferred taxes will add up.
Summary
In this article we defined:
- What a 401k is
- How these pension accounts work
- The annual contribution limits of a 401k
- And the benefits of these accounts for your saving aspirations.
If you want to plan for your financial future, a 401k helps you make forced savings. This way you don't end up spending all of your income on travels or nights out.
By taking a disciplined approach and maximizing savings over time, a 401k can help you plan for the future you want by preserving and protecting future cash flows.