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Why Should You Consider a 401(k)?

Why Should You Consider a 401(k)?

August 22, 2019

Most Americans have heard of 401(k) retirement plans. These are typically employer-sponsored plans that allow pre-tax contributions by the employee along with employer contribution or a profit-sharing feature. However, if you are a small business or self-employed, you can also utilize an individual 401(k) and enjoy the great advantages this plan offers.

Whether you are a small business, self-employed, or work for a company that offers a 401(k), IRS rules that govern these plans are the same. But, if you are self-employed, you can make both employee and employer contributions to your plan, which is a pretty powerful investing strategy.

Benefits of a 401(k) retirement account:

  • Offers much higher contribution limits than a traditional or Roth IRA
  • You have the ability to borrow money from your plan
  • Contributions are tax-deferred; taxes are paid when distributions are taken
  • There is a Roth 401(k) option available to make contributions with post-tax dollars; in this case, earnings are tax-free

How does a 401(k) plan work?

Employee Contributions

Generally, employees make pre-tax contributions to the plan in the form of salary deductions. However, these contributions are made with post-tax deferrals if you are using the Roth option.

If you are self-employed using an individual 401(k), you are considered an employee and an employer. So, you can take advantage of contributions in both of those capacities.

The employee contribution limits in 2019 cannot exceed $19,000. But, you are allowed an additional $6,000 catch-up contribution if you are 50 years of age. The general rule of thumb is to try to max out your contributions to any retirement plan every year. The benefit of compound interest over time has a significant effect on the wealth-building potential of your plan!

Employer Contributions

The employer has the option to make a matching or a non-elective contribution into the employee’s plan. The match can be .50 for every $1 the employee contributes, or something along those lines. Non-elective contributions are at the discretion of the employer and are not dependent on an employee making a contribution. And, the amount of a non-elective contribution can change each year.

Employers can also offer profit-sharing options that can be beneficial for both the employee and employer. This does not mean the contribution is based on the profit the company made in a given year. This feature simply allows employers to wait until the end of the year to determine the amount they want to contribute to their employees’ plans. Profit-sharing is an excellent financial planning strategy for a business. The contributions are tax deductible for the business and can be used to reduce its year-end tax liability.

After all is said and done, the total employee and employer contributions (including forfeitures) are limited to the lesser of 100% of an employee’s compensation or $56,000 for 2019 not including "catch-up" elective deferrals of $6,000. (See IRC section 415(c) for details.)

There are a few nuances regarding contributions to the individual (k) plan if you are self-employed. This IRS publication explains this, but you should also consult with a financial professional to ensure your contributions are in compliance with IRS regulations.

You can choose how your funds are invested.

A 401(k) typically offers an array of mutual funds comprised of stocks and bonds, as well as money market investments. You can go heavy in either direction or allocate funds in a well-planned proportion of different options. Also, you can work with the administrator to invest aggressively or on the conservative side.

The bottom line

Employer-sponsored and individual 401(k) plans offer greater investing freedom and contribution flexibility than other plans. But, they may be a bit more costly to administer and time-consuming to oversee. Consult with a trusted financial advisor to ensure this is the right retirement plan for you and/or your business.