A 401(k) plan is an investment account type designed to help you invest money for your retirement planning. These plans are setup through your employer and the contributions will be deducted from your pay check.
Any money you contribute to a 401(k) will not have income tax deducted from it, so the money inside a 401(k) account is considered to be “pre-tax” which means it hasn’t been taxed yet.
Any money withdrawn from a 401(k) is taxable so it will be added to your income in the year of a withdrawal and will be taxed at your marginal tax rate. Basically the taxes on your contributions are “deferred” to a later date.
Please note that a Roth designated 401(k) does not follow the same rules.
Benefits of a 401(k) retirement plan
Withdrawal tax is usually less than tax deferred on initial contribution – Since you contribute at your marginal tax rate and withdraw at your average tax rate then this account is quite beneficial for most investors.
Rules and penalties
Penalty for early withdrawal – The 401(k) plan has a 10% penalty (with some exceptions) for withdrawal before the age of 59.5.
Contribution limit – 401(k) annual contribution limit is $15,500 for everyone regardless of how much money you earn. Americans older than 50 can contribute an extra $5,000 per year. These contribution amounts cannot be carried over to future years so you have to use them or lose them.