how the 401K retirement plan works.In 1978, the American Congress decided that Americans needed a little more incentive to save more money for retirement. They thought that if they gave people a way to save for retirement and, at the same time, cut their state and federal taxes, they could take advantage of it. The Tax Reform Law was then passed. Part of it authorized the creation of a deferred tax savings plan for employees. The plan was named after its section and paragraph number in the Internal Revenue Code – section 401, paragraph (k). Hence the name 401K.
Ted Benna, who was a benefits consultant, came up with the first version of that plan. His plan was officially accepted by the IRS and the proposed regulations were published in 1981. In 1982, taxpayers were able to take advantage of this new plan for the first time. It took almost 10 years, but the final regulations were published in 1991.
Four things differentiate a 401 (k) plan from other retirement plans.
- When you participate in a 401 (k) plan, you tell your employer how much money you want to go into the account. Generally, you can deposit up to 15% of your salary into the account each month, but the employer has the right to limit that amount. The IRS limits its total annual contribution to $ 18,500 per year.
- The money you contribute comes out of your check before calculation, and more importantly, before you have a chance to get your hands on it. This makes 401 (k) one of the easiest ways to save for retirement.
- If you are lucky, your employer will match a part of your contribution. The corresponding amount that they offer (the free money portion) is their incentive to participate.
- The money is given to a third party administrator who invests in mutual funds, bonds, financial market accounts, etc. They don’t determine the investment mix – you do that. They usually have a list of investment vehicles that you can choose from, as well as some guidelines for the level of risk that you are willing to take.
The downside to the 401 (k)? If you withdraw your money before you are 59.5 years old, you will have to pay tax on it, PLUS a 10% fine to the IRS.
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How secure is your money?
What if your employer declares bankruptcy? How do you know your money is safe? The Employment Retirement Income Security Act (ERISA) that was passed in 1974 includes regulations that protect your retirement income. It requires that all 401 (k) deposits be held in custody accounts in order to keep your money safe in the event that something happens to your employer.
It also sets out the requirements that your employer must follow, such as submitting regular account statements, providing easy access to your account and maintaining compliance so that the plan is fair to everyone in the company. It also requires your employer to provide you with educational materials on investment opportunities in your plan.The only thing you are not exempt from are the natural risks of the stock market.