What is a 401(k) plan and how does it work?

Key facts to know about the tax-advantaged savings plan

Many Americans are placing a greater focus on saving for retirement as the U.S. economy strengthens, and one key plan that can help is a 401(k) account.

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A 401(k) account, named after a section of the Internal Revenue Code, is a tax-advantaged, company-sponsored savings plan, with defined contributions – typically not only made by employees, but their employers as well. In some cases, employers will match contributions up to a certain percent.

For a regular 401(k) account, contributions are not taxed until their withdrawal, at which time they are taxed as ordinary income. In a Roth 401(k) account, contributions are taxed and withdrawals are tax-free.

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Contributions can be made up to a certain established limit. As of 2020, the contribution limit was increased to $19,500, from $19,000. The catch-up contribution limit, for those aged 50 and over, was increased to $6,500 from $6,000.

Employees are typically responsible for selecting their investments based on plans offered by their employers.

When it comes to withdrawals, employees generally have to be at least 59 ½ years old in order to touch the money. Early withdrawal results in a penalty of 10 percent, on top of the income taxes owed.

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How much an individual is required to withdraw varies. The IRS has a life expectancy calculator workers should use to calculate the amount, which is intended to help spread the savings out over their lifetimes.

RMDs are included as ordinary income for the tax year.

Failure to take the RMD results in large penalties, equal to 50 percent of the amount that was required to be withdrawn.

It is estimated that about 55 million Americans had 401(k) accounts as of 2016. The average account balance among people in their sixties, who had worked for more than 30 years, was more than $287,000, according to the Investment Company Institute.

The SECURE Act, which was passed last year, also has a few provisions that may affect 401(k) account access. For example, small businesses will be given tax credits under certain circumstances for having plans in place. They will also have more leeway to band together to offer multi-employer plans. Some businesses will even be required to allow eligible part-time workers to participate.

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