The 401k Retirement Plan
A 401k retirement plan is by definition a tax arrangement that provides an employee the option to defer a portion of their annual compensation for retirement. The funds contributed into the 401k plan are tax deductible when deferred on a pre-tax basis and they will grow on a tax deferred basis until their withdrawal. Qualified plans can be established in two primary ways, either as a defined benefit plan or as a defined contribution plan. A 401k retirement plan is a defined contribution plan, meaning that the balance of the plan is determined by the contributions and the performance of the plan on an annual basis (underlying portfolio’s growth).
Employers are not required to make contributions into this plan on an annual basis, although they can elect to match employee contributions annually. If an employer offers a matching program, it is important to attempt to contribute at least this amount as an employee to take advantage of the free money to grow the retirement account. One thing to take into consideration is that there are annual contribution limits for participating employees, meaning that there is a maximum amount allowed to be contributed annually.
401k plans are designed to be retirement plans, with early withdrawal fees if the funds are taken out prior to the age of 59½. In the event that the funds are withdrawn prior to the age of 59½, there is a 10% withdrawal penalty plus income taxes due on the amount withdrawn. Many 401k plans offer a diverse portfolio selection for the account owners, offering the ability to build a portfolio to meet the investor’s specific risk tolerance and investment goals.
There are several advantages to a 401k retirement plan, including:
- The employee can contribute money into the plan on a pre-tax basis, reducing their total taxable income annually. This can mean substantial savings if the employee contributes the maximum available amount annually.
- The contributions into the 401k plan will grow tax deferred until withdrawn, helping the contributions to grow quicker than in a taxable account. The power of compounding is an important
investment principle to take advantage of for investment growth.
- 401k plans often offer diverse investment selections, giving the account owner the ability to build an ideal investment portfolio for their specific goals and risk tolerance.
- The funds inside of the 401k plan can often be moved to another 401k plan if the employee changes jobs, if the plan permits. Also, the funds in a 401k plan can also be rolled over into an IRA if the employee changes jobs.
Like any investment option, there are both advantages and disadvantages to take into consideration. Some of the disadvantages to a 401k retirement plan include:
- There are penalties to access the funds prior to the age of 59½.
- The contributions made by the employer on behalf of the employee often have a vesting schedule, meaning that if the employee leaves the employer prior to the vesting schedule being completed, they will lose access to these funds.