401k

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A 401k is a retirement savings plan originally created by the United States Congress for U.S. citizens in the Tax Reform Act, passed in 1978. The intention was to encourage Americans to plan ahead for their retirement by lowering their state and federal taxes. In essence, a 401k is a tax-deferred savings plan for employees. It gets its name from the corresponding documentation in the Internal Revenue Service Code.

How a 401k Works

The 401k plan has evolved substantially since it was first introduced more than 30 years ago. Although taxpayers were able to begin saving to a 401k in 1982, it wasn't until 1991 that the most recent version of the plan was devised and implemented.

A 401k retirement plan is a financial savings plan established by employers for employees. Workers make a salary deferral—meaning they set aside a small part of their paychecks—during each pay period, to which an employer may make a matching contribution. Earnings build up and taxes are deferred.

Although the plan offers a reasonable way to save a substantial sum, the IRS does place a cap on the percentage of salary than can be deferred during each pay period. There are also special regulations for how and when an employee can begin using the funds in their 401k. In most cases, an employer will hire an outside financial planner to help organize these funds, and they can help clarify how each company's 401k account works.

Helping Employees Save Money

A 401k plan is a great way for employers to attract employees and keep them loyal to a company. It helps workers earn extra money for retirement, provides 401k tax deductions, and directly deposits savings and earnings into a protected account. Most importantly, it helps employees build up a substantial nest-egg investment to help them retire at a reasonably early age.

That's why many investors recommend new employees get involved in their company's 401k plan as soon as possible. The earlier you start—say in their mid- to late-20s, the younger you'll be for eligible retirement. Even if retiring to Florida sounds like the distant future for someone just out of college, it always pays to think ahead; a 401k and is a critical part of a sound financial plan.

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