Taxation and 401(k) Plans

A 401(k) plan is a tax-deferred savings plan that allows taxpayers to save for retirement and lower their state and federal tax responsibilities. Each month an employer sets aside a portion of their employee's wages before any taxes have been taken out and puts it into the employee's 401(k) account. Many times the employer will match or contribute a percentage of the employee's contribution. 401(k) contributions can lower the amount of income on which you pay taxes. For example, if a person earns $60,000 in one year and contributes $7,000 to their 401(k) account, he or she will only pay income tax on $53,000. Over the course of time, contributions made towards a 401(k) will amount to a substantial reduction in your overall tax liability while at the same time help you save for retirement.

Pre-Tax Payments

Your contributions to the plan are pre-tax, which means that the amount in your account is only taxed when you withdraw from it. The 401(k) retirement plan is one of the more popular plans because the contributions made to it are not taxed before they reach the account. That means you will only be paying taxes on the contributions after retirement when you withdraw from your account, and not before it.

Requirements of 401(k)

An advantage of using a 401(k) is that even after you have established it, you are free to contribute to other retirement plans. An employer can open a 401(k) for employees to lower their taxable income and allow savings for retirement. If your employer provides a 401(k) plan, it is beneficial to participate and begin making contributions towards your future financial security. The earlier you begin making contributions, the more funds you will have after retirement. Other pension plans that employers often use are 403(b) and 401(a).

The annual limit on contributions for 2014 is $17,500. If you are 50 years of age or more at any time during 2014, you can make additional catch-up contributions. These additional contributions can be up to $5,500 for a 401(k) plan.

Early Withdrawal

If for any reason, you make a withdrawal from a 401(k) account before retirement, you will be charged a 10% penalty for the premature withdrawal in addition to the normal tax rate. Therefore, before opening the account, you should make sure that as well as being able to make regular contributions to it, you have alternative funds in case of emergency so that your 401(k) remains undisturbed.

What is SIMPLE 401(k)?

SIMPLE 401(k) is a subsection of the 401(k) that can only be used by small business owners who have a hundred or fewer employees. Like with a regular 401(k), in a SIMPLE 401(k), a taxpayer is not charged taxes on the contributions made until withdrawal. What makes it different from a regular 401(k) plan is that the employer is required to fulfill either one of these two requirements:

1. Make a matching contribution of up to 3% of each employee's pay.
2. Make a non-elective contribution of 2% of each eligible employee's pay.

The employer can only make one of either two contributions. Similar to the regular 401(k), the employer will need to file Form 5500 annually. If you have a 401(k) and you fulfill the eligibility requirements of SIMPLE 401(k), you can convert your regular 401(k) account into a SIMPLE 401(k) account.

Those who are 50 years of age or above can make annual catch-up contributions to their SIMPLE 401(k). The threshold for catch-up contributions is $2,500 for 2013 and 2014.

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