Have you ever wondered what a 401(k) is but are afraid to ask? Since 401(k) retirement plans are a frequent benefit offering in today’s world, many people hear the term but are not always sure what it means. You are not alone.

A 401(k) is a tax qualified retirement account offered by many employers today.  A 401(k) plan is a retirement savings account that allows an employee to divert a portion of their salary into long-term investments. The money the employee diverts from their paycheck, contributes, receives special tax consequences to encourage greater savings for long term goal achievement.

Depending on whether an employee contributes their money to a Roth 401(k) bucket or a traditional 401(k) bucket guides the type of tax treatment the money will receive. Roth contributions are filled with monies that are taxed in the employee’s current paycheck and grows without taxation until the money is taken.  Traditional 401(k) buckets receive the employee’s contribution tax deferred. The taxes are not paid today, but in the future when the owner removes funds. The Roth 401(k) offers tax free growth on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.

Traditional 401(k) buckets receive the employee’s contribution tax deferred. The taxes are not paid today, but in the future when the owner removes funds. They are only taxed on money that is removed and will pay the appropriate taxes and/ or fees at that time. Traditional 401(k) distributions are subject to ordinary income tax, and withdrawal of earnings prior to age 59 ½ may result in a 10% IRS penalty tax.

The amount of wages the employee designates to be contributed is then placed in some investment chosen by the account holder, frequently mutual funds. Mutual fund investing involves risk, including possible loss of principal. The plan will have a variety of choices to place funds for long term investing. The money is invested for retirement.

Because of the tax advantage one receives from the growth in a 401(k) plan, there are maximum amounts of money an employee is permitted to divert from their paycheck annually. The allowable contribution for 2020 is 19,500.00. This limit may be adjusted by the Internal Revenue Service annually.

 401(k) plans are a wonderful benefit provided by some employers. The retirement plan provides a wonderful way to save money on a tax advantaged basis. Check into your benefits package and learn about your options.

This article was written by Helen Hartman, Chartered Retirement Planning Counselor(CRPC) , Professional Plan Consultant(PPC), and Certified Plan Fiduciary Advisor(CPFA), a LPL Investment Advisor Representative of Redwood Financial Network in Solon, OH.

This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.

Securities and Retirement Plan Consulting Program advisory services offered through LPL Financial, a Registered Investment Advisor, member FINRA/SIPC. Other advisory services offered through Redwood Financial Network Corp, a Registered Investment Advisor and a separate entity from LPL Financial.