A Beginner's Guide to Understanding 401k Retirement Plan

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A Beginner's Guide to Understanding 401k Retirement Plan

A Beginner's Guide to Understanding 401k Retirement Plan
  • 11th Mar 2021 |
  • 7,294

A 401(k) plan is one of the most popular retirement plans. Even though the plan is unique to the United States of America, it is considered a global benchmark in retirement planning. Moreover, Non-Resident Indians (NRIs) who return to India after working in the U.S. usually have a 401(k) plan they need to take care of.

So, here is a quick guide to help you understand 401k in India retirement plans:

What is a 401(k) plan?

  • A 401(k) plan is an employer-sponsored retirement plan which allows eligible employees to make contributions.
  • The contributions are deducted from the salary or the wage of the employee. And like an Employee Provident Fund (EPF) in India, the employer also matches the employee contribution to the plan up to a specific limit.
  • In India, EPF is tax-free at the hands of the employee. But in a 401(k) plan, only employee contribution is tax-free, and employer contribution is considered pre-tax. Besides, like an EPF plan, 401(k) plan contributions are tax-deferred.
  • These plans’ contributions and investment earnings are taxed as ordinary income during withdrawal. That said, withdrawals from a 401k in India account are allowed after the employee is 59.5 years old. Any premature withdrawals result in a penalty of 10% on the sum withdrawn, in addition to the regular income taxes.
  • 401(k) in India is a “qualified” retirement plan; the IRS provides it with specific tax benefits, the most significant of which is the exclusion from paying taxes on the returns from your initial investments. You will only be subject to taxation once you retire when you take money out.
  • Your employer is not required to make any contributions to your 401(k) plan, and they are not even required to provide employees with a 401(k) plan.
  • For those employees who receive one, it’s a great perk. Even without employer contributions, a 401(k) plan offers interest rates that are much greater than those of a regular savings account.

How does a 401(k) work?

The employer-sponsored 401(k) plan allows employees to decide the amount they wish to contribute, which is deducted from their monthly paychecks. The money deducted is further invested in a chosen plan for the long term. This retirement plan allows employees to invest in stocks, bonds, mutual funds, etc.

In an EPF, employees contribute a defined share of their salary, and the employer contributes the same.

What are the contribution limits of a 401(k)?

In 2022, 401(k) contribution limits for individuals are $20,500, or $27,000 if you’re 50 or older. As per EPF rules, all employees earning more than ₹15,000 have to contribute 12% of their wage plus dearness and retaining allowance towards EPF. The employer contributes the same percentage. The employee can also choose to increase the contribution percentage. That said, for establishments with less than 20 employees, the contribution rate for both employer and employee is 10%.

Key challenges of a 401(k) plan

Despite its popularity, 401k retirement plans are not the ideal plan because:

  • These are defined contribution plans; hence, the employee primarily bears the investment risk.
  • Limited investment options restrict the potential return on funds.
  • These are not guaranteed plans, and the pension is based on the balance in the account at retirement.
  • These plans are not ideal for emergency usage since they have low liquidity and strict withdrawal rules.

Overall, 401(k) plans in the USA or EPF plans in India are standard plans beneficial for retirees only if clubbed with other wiser 401k retirement plans like Kotak Lifetime Income Plan and Kotak Premier Pension Plan. The former assures lifetime income. At the same time, the latter allows retirees to accumulate significant retirement corpus with assured benefits on death and vesting. Make an informed choice!

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