What Is a 401(k) and How Does It Work?

Since 1978, employers have offered a 401(k) as a savings vehicle to help employees and business owners save for retirement. This plan offers unique short and long-term tax advantages for both parties.

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What is a 401(k)?

  • A 401(k) isn’t a traditional savings account. It’s a long-term investment account that allows your money to grow before you pay taxes on it.
  • Money from an employee’s paycheck defers into a 401(k) account, reducing this year’s taxable income.
  • The money in your account grows year after year, compounding as savers earn interest on their interest.
  • Taxes are paid on that money as it’s withdrawn in retirement, typically when one’s tax bracket is lower.

How does a 401(k) work?

  • The employer sets up a company 401(k) with a plan provider and plan custodian.
  • Many businesses choose to match a percent of employee contributions, helping savings grow faster.
  • The employer match is like FREE MONEY that rewards employees for participating and saving.
  • Employees choose how much of their pay will be deposited into their 401(k) account each pay period (before taxes are deducted) and how those dollars will be invested by the plan custodian.
  • 401(k) funds include stocks, mutual funds, bonds, exchange-traded funds, index funds, and more.
  • Depending on the plan, participants may withdraw from their accounts at age 55 or 59.5 penalty-free.
  • Upon withdrawal, employees pay taxes on the money as if it were regular income.

What tax advantages do 401(k)s have?

Employees enjoy:

  • Tax deductions now:

    401(k) contributions are deducted from employees’ taxable income for the year 2023, to a maximum of $22,500 for those under 50 and $30,000 for those age 50 and older. So, if you make $100,000 this year and contribute the maximum $30,000, you will owe taxes on $70,000. If your tax rate is 25%, the $30,000 you put into the plan means $7,500 less in federal taxes paid. You save that $30,000 for retirement, but it only costs you $22,500, assuming you chose traditional pre-tax contributions.

  • OR tax savings later:

    If you expect to be in a higher tax bracket in retirement, you may opt for Roth 401(k) contributions where you don’t reduce your earned income by the contribution amount, but all funds grow tax-free and no tax is owed when you take the money out in retirement.

Employers enjoy:

  • New plan startup tax credits:

    Employers can write off $250 per Non-Highly Compensated Employee enrolled in the plan – for a savings of $500 to $5,000 per year, over three years (up to $15,000 total).

  • Auto-enrollment tax credits:

    Employers who choose auto-enrollment can write off $500/year for the first three years ($1,500 total). This credit applies to employers who convert an existing 401(k) plan to automatic enrollment.

  • Deductions for individual contributions:

    A business owner can deduct up to $66,000 from taxable income per year when the maximum $22,500 is reached, along with a 25% profit-sharing contribution. The amount can be doubled if the business owner’s spouse also contributes to the plan.

  • Deductions for employee contributions:

    The business owner can deduct all employer match or Safe Harbor contributions made to the plan from the business income for the year.

What’s the benefit of the employer match?

For employers, offering a 401(k) with matching contributions is a generous benefit for current and prospective employees that reduces recruiting costs, cuts employee turnover, and improves productivity. For employees, a 401(k) match is free money that grows a retirement nest egg exponentially year over year.

To learn more about the 401(k) plans offered to small businesses, contact Ubiquity today.

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© 2023 Ubiquity Retirement + Savings
Privacy Policy
44 Montgomery Street, Suite 300
San Francisco, CA 94104