When you think of retirement, what comes to mind is a 401(k) plan.

What is it, and how does it work?

The term "401(k)" refers to a retirement savings and investing plan that firms provide to employees. Employees who contribute to a 401(k) plan receive a tax deduction for the money they put in. Employer contributions are automatically deducted from employees' paychecks and invested in mutual funds of the employee's choosing (from a list of available offerings). The annual contribution maximum for 401(k) plans is $19,500 in 2021 and $20,500 in 2022 (or $26,000 in 2021 and $27,000 in 2022 for individuals over the age of 50 in 2021 and 2022).

The name of this sort of plan derives from a portion of the tax law — specifically, subsection 401(k) — that was designed to form this type of arrangement. When employees sign up for automatic deductions from their paychecks, they are able to make contributions to their individual accounts. Depending on the type of plan you have, you will receive a tax deduction either when you make contributions or when you remove money from the account in retirement.

If this is the moment at which you fell asleep during job orientation, you missed the most important portion — and this is especially true if there is free money involved (more on that below).

What is the procedure for obtaining a 401(k)?

Your company provides you with a 401(k) plan. Unfortunately, not all firms provide employees with access to a 401(k). If you find yourself in this category, don't be discouraged. Individual retirement accounts (IRAs), which are the other major retirement savings vehicle, nonetheless provide the same tax benefits as a 401(k).

This may lead to the natural question: What exactly is an Individual Retirement Account (IRA)? These accounts have a number of appealing advantages (such as a greater variety of assets and often reduced costs), but they also have some disadvantages (lower contribution limits and restrictions for high earners). How a 401(k) varies from an IRA, as well as how to take benefit of both at the same time, are discussed here.

What exactly is in it for you?

Many companies may match a part of your savings up to a certain amount. The employer match in 401(k) plans is the benefit that garners the most attention. Instead of continuing reading, stop right now and go fill out the necessary paperwork if you work somewhere that matches your contributions dollar for dollar or 50 cents on the dollar, up to a maximum of 6 percent of your total contribution amount. Put in enough money into your account to qualify for the free money, even if you don't do anything else.

You may experiment with our 401(k) calculator to discover how much money you can save and how much impact modest adjustments, such as any corporate match, will make over time if you contribute to a retirement plan.

This is an appropriate opportunity to point you that there are various different types of 401(k) plans, including the two most common: the standard 401(k) and the Roth 401(k) (k). The classic (or regular) 401(k) provides an immediate tax deduction on your contributions. Contributions to a Roth 401(k) are made with after-tax cash, which means that you will not be able to deduct the money from your taxes for that tax year. But don't be concerned, Roth's reward will come later.

Contributions made before taxes make saving a bit less unpleasant. Contributions to a standard 401(k) plan are deducted from your paycheck before the Internal Revenue Service gets its part, which increases the value of every dollar you save. Take, for example, the fact that Uncle Sam typically takes 20 cents out of every dollar you make to cover taxes. To save $800 a month outside of a 401(k), you must earn $1,000 a month — $800 + $200 to pay the Internal Revenue Service's deduction. When they — whatever "they" is in your life — suggest that you won't miss the money, they're referring to anything similar to the following. (For reference, below are the donation limitations that should be targeted for this year.)

Contributions might result in considerable reductions in your income taxes. Pretax contributions to a typical 401(k) offer an additional benefit in addition to increasing your savings potential: they reduce your total taxable income for the year in which they are made. Consider the following scenario: you earn $65,000 per year and contribute $19,500 to your 401(k) (k). It is possible that you will only owe income taxes on $45,500 of your paycheck, rather than the total $65,000 that you received. That is, investing for the future allows you to avoid paying taxes on $19,500 of your earnings.

Uncle Sam does not intervene in the growth of the investments in the account... Once money has been deposited into your 401(k), the force field that prevents it from being taxed stays in place. Traditional 401(k)s and Roth 401(k)s are both eligible for this benefit. You will not be subject to taxation on any investment growth as long as the money is kept in the account. No, not on the basis of interest. Not in the case of dividends. For the time being, there will be no taxation on any investment profits.

The classic 401(tax-repellent )'s characteristics aren't guaranteed to persist in perpetuity. Remember when you were able to claim a tax deduction for the money you put into the retirement plan? After all, the Internal Revenue Service ultimately comes along to take a piece. In technical words, your contributions and investment growth are tax-deferred, meaning that taxes are not levied on them until you begin to take funds from the account in retirement. At that moment, you'll be obligated to pay income taxes to the government.

It is at this point that the Roth 401(superpower )'s is apparent.

A Roth 401(k) allows you to get your taxes out of the way immediately. It provides the same tax protection on your investments while they are in the account; you will owe no taxes on the money while it grows as a result of your contributions to the account. However, unlike eligible withdrawals from a traditional 401(k), when you begin receiving distributions from a Roth, you owe nothing to the Internal Revenue Service.

How does that sound, exactly? Remember how we stated earlier that, depending on the sort of 401(k) plan you have, you may be eligible for a tax credit either when you make contributions or when you take money from the account when you retire? The Internal Revenue Service (IRS) can only charge you income taxes once. Because your contributions to a Roth 401(k) were made using after-tax monies, you've already paid your portion of the required minimum distribution. Consequently, when you take money in retirement, both you and Uncle Sam are already financially satisfied with one another.

You are welcome to take it with you.

In the event that you decide to leave your current employment for another, you may (and should) take your 401(k) with you. This will not be placed in a box with your other items; rather, you will need to transfer the funds from your old account to a new one — and for many individuals, changing their 401(k) to an IRA is a wise decision. The guide on 401(k) rollovers can come in handy when the time comes to make the transfer.