401(k) Retirement Plan: Everything you need to know

A 401(k) is a popular retirement savings plan offered by many employers in the United States. Named after a section of the US Internal Revenue Code, 401(k) offers tax advantages to the saver. Let’s find out what is a 401(k) Retirement Plan and how does it work? Here is a quick guide to 401(k) investments for NRIs who have availed this plan.  

401(k) Retirement Plan: Everything you need to know
401(k) Retirement Plan: Everything you need to know

Also Read: Withdrawing 401k from India and the associated tax implications

What is the 401(k) retirement plan

A 401(k) is a company-sponsored retirement account that an employee can contribute to. Employees who sign up for a 401(k) agree to contribute a portion of their wages to fund a 401(k) account. The employer may choose to match a part or all of that contribution. An employee gets to invest the funds saved in his/her 401(k) account in mutual funds offered by the plan. 

The 401(k) plan was designed by Congress to encourage employees to save for retirement. Like the EPF plan in India, 401(k) is tax-deferred, which means the full benefits are known only at the time of retirement and regular payments are credited to the plan. 

How does a 401(k) plan work

There are mainly two types of 401(k) accounts offered by employers, each with different tax advantages:

  • Traditional 401(k): A traditional 401(k) is funded from the employee’s pre-tax gross income. The taxable income of the employee is reduced by that amount. Tax is not applicable on the amount paid or the profits it earns until the employee withdraws it after retirement. The contributions are invested in mutual funds and other financial instruments and grow in value over time. 
  • Roth 401(k): Roth 401(s) is funded by the post-tax income of an employee, which means the contribution doesn’t reduce your taxable income. When you withdraw money after retirement, no additional taxes are due on the employee’s contribution or profits it earned over the years. 

How does 401(k) contribution work?

Employees decide what percentage of their income to contribute to a 401(k) account every year (subject to IRS limit). You can choose to save a percentage of your annual salary in a 401(k) account. Employees are allowed to adjust the contribution level up or down as many times as rules allow. You can discontinue contributions at any time, for any reason. 

Let’s say your monthly salary is $4,000 and you choose to contribution 5% of your annual salary in the company’s traditional 401(k) account. As a result, $200 would be credited to your 401(k) account from your paycheck every month. In this case, your taxable income would be $38,00. If you chose to contribute to a Roth 401(k), the $200 would be deducted from each paycheck after taxes. 

How does employer 401(k) matching contribution work?

The employer may match part or all of its employees’ 401(k) contributions, up to a certain percentage of their salary. Employers use various formulas to calculate that match. For example, an employer can match $0.50 for every dollar the employee contributes, up to a certain percentage of salary. 

Continuing from the above example, consider the impact on your 401(k) investment of a dollar-for-dollar employer match, up to 3% of your salary. If your contribution is 5% of your annual salary and you get $4,000 per instance, with each paycheck, you would be contributing $200 and your employer would contribute $120. 

Annual 401(k) contribution limits

The maximum 401(k) investments made by an employee can be up to $19,500 for 2020 and 2021. Individuals aged 50 years or older can deposit an extra $6500 in catch-up contributions, for a combined contribution of $26,000. The limit is applicable to all 401(k) investments, even if you split them between pre-tax and Roth contributions, or even if you open two separate 401(k) accounts with two employers in a year.   

Withdrawing funds from your 401(k)

401(k) plans are designed to provide you with income after retirement. As per IRS rules, you can’t withdraw funds from a 401(k) account without penalty until your age is 59 ½. Early withdrawals before the predefined age of 59 ½ are subject to a tax penalty of 10 % of the amount withdrawn + a 20% mandatory income tax withholding of the amount received from a traditional 401(k).  

Once you reach  59 ½, you can start withdrawing distributions from your account. Individuals born before June 30, 1949, must begin withdrawing funds from their 401(k) at age 72 (or  70 ½).

401k withdrawal from India or by NRIs

A large number of NRIs work in the USA. Some of them return to India before retirement while some stay there. They can withdraw 401(k) accordingly, but still, you may have several questions regarding the 401k withdrawal from India, tax implications on it, and so on and so forth.

Also Read: What to do with your 401(k) if you move back to India

Moving back to India? How Does a 401k Plan Work

SBNRI understands the struggles NRIs go through considering the withdrawals from their 401k retirement account in India. Even though we have tried to make the taxation aspects clear and transparent, doubts and queries can always arise and it’s a good thing if that happens. The more questions you ask, the more informed you become and eventually the entire process becomes very convenient and seamless.

You can download SBNRI App from the Google Play Store or App Store to ask any questions related to investment in stock market/ mutual funds, NRI account opening online and tax filing in India. To ask any questions related to withdrawing 401k from India. Also, visit our blog and YouTube channel for more details. 

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