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As more Americans shoulder the responsibility of funding their own retirement, many rely increasingly on their 401(k) retirement plans to provide the means to pursue their investment goals. That’s because 401(k) plans offer a variety of attractive features that make investing for the future easy and potentially profitable.

What is a 401(k) plan?

A 401(k) plan is an employee-funded savings plan for retirement. For 2016, a 401(k) plan allows you to contribute up to $18,000 of your salary to a special account set up by your company, although individual plans may have lower limits on the amount you can contribute. Individuals aged 50 and older can contribute an additional $6,000 in 2016 – so-called “catch up” contributions.

How are 401(k) plans taxed?

401(k) plans come in two varieties: traditional and Roth-style plans.

A traditional 401(k) plan allows you to defer taxes on the portion of your salary contributed to the plan until the funds are withdrawn in retirement, at which point contributions and earnings are taxed as ordinary income. In addition, because the amount of your pretax contribution is deducted directly from your paycheck, your taxable income is reduced, which in turn lowers your tax burden.

A Roth 401(k) plan features after-tax contributions, but tax-free withdrawals in retirement. Under a Roth plan, there is no immediate tax benefit. However, plan balances have the potential to grow tax free; you pay no taxes on qualified distributions.

Matching contributions

One of the biggest advantages of a 401(k) plan is that employers may match part or all of the contributions you make to your plan. Typically, an employer will match a portion of your contributions, for example, 50% of your first 6%. Under a Roth plan, matching contributions are maintained in a separate tax-deferred account, which, like a traditional 401(k) plan, is taxable when withdrawn. Total contributions, including employee and employer portions, cannot exceed $53,000 in 2016. Note that employer contributions may require a “vesting” period before you have full claim to the money and their investment earnings.

Distributions

Employees are eligible to take penalty-free distributions after 59½ (or age 55 if you are separating from service with the employer from whose plan the distributions are withdrawn), although there are certain exceptions for hardship withdrawals. If a distribution is not qualified, a 10% IRS additional federal tax will apply in addition to ordinary income taxes on all pretax contributions and earnings.

When you change jobs

When you change jobs or retire, you generally have four different options for your plan balance:

  1. Keep your account in your former employer’s plan, if permitted;
  2. Transfer balances to your new employer’s plan;
  3. Roll over the balance into an IRA;
  4. Take a cash distribution.

The first three options generally entail no immediate tax consequences; however, taking a cash distribution will usually trigger 20% withholding, a 10% additional federal tax if taken before age 59½, and ordinary income tax on pretax contributions and earnings.

Borrowing from your plan

One potential advantage of many 401(k) plans is that you can borrow as much as 50% of your vested account balance, up to $50,000. In most cases, if you systematically pay back the loan with interest within five years, there are no penalties assessed to you. If you leave the company, however, you may have to pay back the loan in full immediately, depending on your plan’s rules. In addition, loans not repaid to the plan within the stated time period are considered withdrawals and will be taxed and penalized accordingly.

Choosing investments

Most plans provide you with several options in which to invest your contributions. Such options may include equity mutual funds for growth, bond funds for income, or cash equivalents for protection of principal. This flexibility allows you to spread out your contributions, or diversify, among different types of investments, which can help keep your retirement portfolio from being overly susceptible to different events that could affect the markets.

A 401(k) plan can become the cornerstone of your personal retirement savings program, providing the foundation for your financial future. Consult with your plan administrator or financial advisor to help you determine how your employer’s 401(k) plan could help make your financial future more secure.

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