As pensions have become increasingly endangered, what’s replaced them has largely been the 401(k) plan. Named after a section of the 1978 Revenue Act, 401(k) plans allow employers to place part of their employees’ salaries into a retirement fund on a tax-deferred basis. Instead of paying income tax on that share of the salary when they receive it, the fund participants only pay income taxes during the distribution phase. Because their income is likely to be lower at that time than when they were working, the 401(k) plan reduces their tax liability.
Employers can also match their employees’ contributions, adding to the value of their staff’s benefits. Before you start, you really need to know when you can retire?
Retiring with a 401
There are limits on the amount that both the company and the employee can place in their 401(k) each year. In 2021, employees can place up to $19,500 a year in their 401(k) plans or $26,000 if they’re aged over 50. Add in the employer’s matching contributions and in 2021, total 401(k) contributions each year can reach $58,000 or $64,500 for people aged over 50.
Unlike pensions, 401(k) plans are defined-contribution. Participants in a 401(k) plan won’t know exactly how much they’ll receive until the distributions begin. They can determine the amount that they contribute each month and each year, but there are no guarantees about the amount that they’ll receive.
Distributions taken before the age of 59.5 generally face a 10 percent early withdrawal penalty tax in addition to income tax. It rarely pays to take money out of a pension fund early. But participants usually—although not always—have to begin making withdrawals from the age of 72.