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What Is a 401kor

What Is a 401kor

What Is a 401k

401k stands for 401k, which is the name of a 401k plan. 401k plans are retirement plans paired with a person’s employer. They are set up to defer until after the individual retires and maximize the tax deferral benefits. 401k plans include three major types of investments.

Tax

With a traditional 401(k), employee contributions are deducted from gross income, meaning the money comes from the employee's payroll before income taxes have been deducted. As a result, the employee's taxable income is reduced by the total amount of contributions for the year and can be reported as a tax deduction for that tax year. No taxes are due on the money contributed or the earnings until the employee withdraws the money, usually in retirement. The earnings in a 401(k) account are tax-deferred in the case of traditional 401(k)s and tax-free in the case of Roths. When the traditional 401(k) owner makes withdrawals, that money (which has never been taxed) will be taxed as ordinary income. Roth account owners have already paid income tax on the money they contributed to the plan and will owe no tax on their withdrawals as long as they satisfy certain requirements.

On the other hand, employees who expect to be in a higher bracket after retiring might opt for the Roth so that they can avoid taxes on their savings later. Also important—especially if the Roth has years to grow—is that there is no tax on withdrawals, which means that all the money the contributions earn over decades of being in the account is tax-free. Withdrawing the money is usually a bad idea unless the employee urgently needs the cash. The money will be taxable in the year it's withdrawn. The employee will be hit with the additional 10% early distribution tax unless they are over 59½, permanently disabled, or meet the other IRS criteria for an exception to the rule. (Source: www.investopedia.com)

 

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