How does a 401(k) work?

A 401(k) works by employees deferring a portion of their income via automatic deductions from their pay cheques. This deferred money is taxed when it is withdrawn, and can be directed to any investment listed in the plan. These funds must be left in the defined contribution plan until the employee is aged 59 and a half years, with a few exceptions.

A 401(k) works by employees deferring some of their income through automatic deductions from their paycheques. This money is left untaxed, and can be directed into investments listed in the plan. This money has to remain in the plan until the employee is 59 and half years old, unless special provisions apply, or the employee is willing to pay a penalty. For employers, 401(k) rules are complicated, so it’s a good idea to seek advice from an international tax advisor. Here is a brief summary in the meantime:

  • The US government allows employees to make tax-free retirement savings (the money ‘grows’ tax free and is taxed when withdrawn) through something called a 401(k) plan. However, this is only on the condition that all employees benefit to the same degree as higher paid owners and managers.
  • IN a ‘safe harbour 401(k)’ plan, a company can either contribute 3% of an employee’s salary to every employee, or agree to match the employee’s contributions up to 4% of their salary. 99% of US businesses opt for a ‘safe harbour 401(k)’.

There are various ways to match, but at Foothold America we have opted to make an automatic match (up to 4%).

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