A 401(k) is a tax deferred
retirement plan, which allows a worker to save for retirement and have
savings invested while avoiding paying taxes on both the money saved
and money earned. Taxes are deferred until the withdrawal. Withdrawals
are normally not made until retirement when the borrower will
theoretically be earning far less in income, and therefore will have to
pay less in taxes over the long haul.
401(k) plans are normally sponsored by employers, who provide access to
a 401(k) plan as a benefit to their employees. The employer will then
choose a variety of investment funds and in most cases allow their
employees choose the allocation between the selected funds. Some
employers provide a 401(k) “match” to their employees, where they will
contribute an additional sum of money based on the employee’s
contribution. Employer matching programs vary widely.
Federal guidelines set 401(k) contribution limits. In 2009 and 2010,
the individual contribution limit is set at $16,500 per individual.
Individuals over the age of 50 may contribute an additional $5,500 in
the form of “catch up” contributions. Employer matching contributions
are also limited. In 2009, employer and employee 401(k) contributions
are limited to the larger of 100% of the employee’s salary or $49,000.
A 403(b) plan is a tax deferred retirement plan with very similar tax
laws as a 401(k). The 403(b) plan, sometimes referred to as a
tax-sheltered annuity, is a retirement plan for employees of public
education organizations, health care organizations, and other tax
exempt organizations.
Both 401(k) and 403(b) contributors also have the option of investing
in designated Roth plans. A Roth 401(k) and Roth 403(b) allow
participants to contribute and invest after tax income, while allowing
the contributions to grow tax free. If certain requirements are me,
withdrawals from the Roth accounts will be tax free.
Another benefit of investing in 401(k) and 403(b) accounts is
bankruptcy protection. Under The Bankruptcy Reform Act of 2005,
401(k)’s, 403(b)’s, and other retirement vehicles are protected from
creditors during bankruptcy proceedings. If one withdraws from a
retirement account prior to claiming bankruptcy, the withdrawals may be
taken by creditors.
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