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What is a 401K?

A 401K is a savings plan for retirement.
Employees decide how much is put into the account from each paycheck.
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  • Written By: Mancunian
  • Edited By: Jay Garcia
  • Last Modified Date: 01 November 2014
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A 401K is a long term savings plan that is designed to accumulate money towards retirement. It is so-named after the section of the US Internal Revenue laws that allow this particular kind of financial planning option. These plans are typically only available through an employer; the money is generally taken out of the employee’s paycheck every week or month and deposited in the account.

An employee chooses the amount she wants taken from her check every payday to contribute to the plan. This money is then invested in such things as money market funds, growth funds, and index based stock funds, which will accumulate value over time. The maximum pre-tax amount an employee can contribute to the plan varies by year, although the amount is generally around $16,000 US Dollars (USD).

401k plans are generally safe and effective, although there are some risks as with any financial plan; if money is put in to certain more risky investments, the account may not grow as quickly as anticipated. The funds are not protected by the Pension Benefit Guaranty Corporation (PBGC) which safeguards the assets of most other pension plans.

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One of the biggest advantages of a 401K is that many employers will typically match employee contributions. If an employee decides to contribute 10% of her salary every month towards her plan, her employer may choose to match this and contribute the same dollar amount itself. Employers are not obligated to match contributions, but almost 80% of companies do to some extent.

These plans have several other advantages: they are fairly easy to understand and participate in, they often offer many different investment options, and a person can choose to invest in safe or risky options. Many also allow the participant to change not only the percentage of her salary she is contributing, but also the investments that she is allocating money to.

An employee may also borrow money from a plan account. A 401K loan does not appear on a credit report, and there is no restriction on what the money can be used for. There may be charges and fees involved in taking out the loan, however, and an employee also loses out on any employer matching contributions while paying off the loan. There is often a minimum loan amount of $1,000 USD.

For most participants, a 401K is a convenient and straightforward way to save for their retirement. Although the plan isn’t perfect, it is perhaps one of the safest investment plans around and is ideal for people who don’t like to take too many risks.

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cafe41
Post 4

Sunny27-I think that a 401K is easy for most people to invest in retirement because you just have to establish what percentage of your salary will go into the account and you never see that money.

This way you can get used to saving for retirement and not worry about it. However, there are limits to how much you can contribute each year. The 401K rules state that the maximum yearly contribution is $16,500.

If you are 50 and over there is a catch up provision that allows you the opportunity to invest an additional $5,500 beyond the maximum limit.

If your company does not offer a matching for your 401K contributions then you should consider opening an IRA account. You can open a traditional IRA if your income is too high for the Roth IRA.

The traditional IRA works like a 401K but you can invest in any security you would like. You can invest in mutual funds, bonds, stocks, and even real estate. This money grows tax deferred until you retire.

The Roth IRA grows tax free and you have to pay taxes on your initial contribution each year.

Sunny27
Post 3

Bhutan-I know that the 401K and 403B are pretty much the same. The 401K is a retirement plan for a for profit business while a 403B is a retirement plan for a non-profit business.

A 403B also has no administrative costs associated with it and the employer contributions can be withdrawn and placed in an annuity without tax penalty.

Bhutan
Post 2

Moldova-I think that the 401K benefits are fantastic. First, it lowers your taxable income for the year and it may even put you in a lower tax bracket due to your contributions.

The employee also receives, in most cases, a percentage of matching funds as additional money in the account. The drawback is that 401K has a small amount of investment options and you really have to make a choice among the options offered.

Some of the mutual funds are loaded funds that pay a 5% commission fee immediately upon entering the fund or over time as in a class B share fund.

These types of mutual funds eat away at any gains you may make because the expenses are so high.

I also heard of a Roth 401K. This account works similar to a Roth IRA in which the funds are taxable now, but upon withdrawal the money is tax free.

You pay taxes on the amount you invest year after year and when you retire that money is tax free. This is a great option if your employer offers it because you do not have to worry about paying taxes when you retire.

Moldova
Post 1

Companies created a 401K in order to replace traditional pensions that offered the retired employee an annuity.

Instead the individual employee funds the 401K retirement plan and many companies offer an additional three to five percent of any employee matching in order to encourage the employee to save.

This is a tax deferred account that is taxed at the retiree’s income level at retirement. A 401K distribution can be taken no earlier than 59 ½ or the employee will face a 10% penalty and the income withdrawn will be considered ordinary income and they will be taxed a second time.

These are the 401K regulation which is why it is best to do the 401K withdrawal at retirement only. Some people seek 401K loans and then pay them back. This is not a good idea because not only do you have the double taxation problem but you are also faced with having to pay the loan back immediately if you become separated from the company due to a layoff or a firing.

This is probably the last thing you want to worry about when you lose your job.

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