What do you understand about a 401(k) plan?
QuickBooks Payroll 401k plan, authorized under subsection 401(k) of the Internal Revenue Code, enables employees to allocate a portion of their paycheck to a retirement savings account with employer contributions. This “qualified” plan offers tax benefits under IRS guidelines. The type of 401(k) plan determines when the tax break is applied – either at the time of contribution or withdrawal during retirement.
As an employer, maintaining accurate payroll records and reports is crucial to ensure that all 401(k) plan contributions are accounted for tax purposes. These contributions will be reflected on an employee’s W2 form.
Additionally, some employers provide an attractive benefit known as the 401(k) match. This means that the employer will contribute a certain amount of cents for every dollar the employee contributes, up to a specific limit. For instance, a recent study by Vanguard revealed that approximately 51% of employers offer this matching benefit. Among these employers, the match can vary:
Single Tier Formula: Almost three-quarters (70%) of companies provided a 50% contribution match, up to a maximum of 6% of an employee’s salary.
Multi Tier Formula: Around 20% of companies provided a 100% match on the first 3% of an employee’s salary, followed by a 50% match on the subsequent 2% of the salary.
Dollar Cap: Out of the companies surveyed, 6% had a single or multi-tiered formula with a maximum benefit of $2,000.
Other: Out of all companies, 2% provided a variable compensation structure that was dependent on age, duration of employment, or comparable factors.
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The allure of employer 401(k) matches lies in the fact that they represent a form of free money contributed by your employer to your retirement plan. Nevertheless, once you reach retirement or cease employment with the company sponsoring your 401(k) account, these matches will no longer be provided.
Benefits of opening a QuickBooks Payroll 401k
Now that you’re aware of the 401(k) plan, let’s look at some of the advantages that it has to offer. Some of the primary benefits includes:
Tax Breaks: With a traditional 401(k), your taxable income for the year is lowered because contributions are tax-deferred. For instance, contributing $15,000 annually to a $60,000 salary results in a $45,000 taxable income. Additionally, savings grow tax-deferred, meaning interest, dividends, and capital gains are not taxed. However, withdrawals during retirement are taxed as ordinary income. In contrast, with a Roth 401(k), taxes are paid upfront, so withdrawals in retirement are tax-free, including earnings.
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Lower Tax Bracket: A reduced taxable income could result in falling into a lower tax bracket for the year, potentially leading to a smaller tax bill for that year.
Shelter from creditors: The Employee Retirement Income Security Act (ERISA) of 1974 offers protection for your 401(k) retirement savings in the event of financial hardship. This crucial legislation prevents creditors from making claims against your retirement funds, providing you with peace of mind during challenging financial times.
Employer Match: Many individuals prioritize employer matching contributions in their 401(k) plans, as it effectively provides free money. To maximize your retirement savings, aim to contribute up to the employer’s contribution limit. For instance, if your employer matches contributions up to $6,000 of your salary on a 1:1 basis, contributing $6,000 annually would result in a total of $12,000 in your 401(k) account for the year. This approach allows you to take full advantage of your employer’s matching program, boosting your retirement savings.
High Contributions Limit: The Internal Revenue Service (IRS) establishes annual contribution limits for individuals participating in 401(k) retirement plans. In both 2020 and 2021, the contribution limit was set at $19,500.
Contributions after age 72: When it comes to retirement accounts, there are usually required minimum distributions (RMDs) that you need to take each year. However, 401(k) plans offer an exception. As long as you are still employed and your ownership stake in the company is less than 5%, you can continue contributing to your 401(k) plan.
How to invest your 401(k)?
401(k) plans are retirement savings accounts that are sponsored by employers, and the investment options available are typically limited. Instead of investing in individual stocks and bonds, 401(k) plans invest in mutual funds, index funds, and exchange-traded funds, which are baskets of securities.
When contributing to your 401(k), it’s important to consider your risk tolerance, which is your ability to withstand financial losses. Stocks generally carry more risk than bonds and other fixed-income investments, so it’s generally recommended to allocate a higher percentage of your 401(k) to stocks when you’re younger and gradually reduce the allocation as you approach retirement. A common rule of thumb is to subtract your age from 110 to determine the percentage of your 401(k) that should be invested in stocks, with the remaining percentage invested in bonds.
However, this is just a general guideline, and you should also consider your personal financial situation and how comfortable you are with the possibility of losing money in the event of a stock market downturn.
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Rules for withdrawing from your 401(k)
To encourage retirement savings, the government provides tax benefits for qualified retirement accounts such as 401(k) plans. To discourage early withdrawals, account holders cannot receive qualified distributions until they reach 59 1/2. Any withdrawals before then incur a 10% early withdrawal penalty.
However, some exceptions to the 59 1/2 age-limit exist. A 401(k) participant can withdraw funds before reaching this age in certain situations, including:
- The death of the account owner
- The account owner suffers a total and permanent disability
- The owner has unreimbursed medical expenses in an amount greater than 10% of their adjusted gross income (AGI) for 2021, or greater than 7.5% of their AGI for 2017–2020
- Immediate and heavy financial need
Conclusion!!
401(k) plans, employer-sponsored retirement plans, automatically deduct a percentage of an employee’s salary and invest it in stocks, bonds, mutual funds, and other securities. These plans provide numerous benefits, such as tax deductions, protection from creditors, and employer-matching contributions.
Participants can roll over their 401(k) funds into a new employer’s 401(k) plan or an Individual Retirement Account (IRA) when changing jobs. QuickBooks can assist with payroll withholding and other tasks related to managing employee retirement contributions. Our payroll software for small businesses can guide you through reporting, reconciling, and understanding your payroll processes.
