The 401(k) or 401k plan, named after the section of the tax code that governs them, is a pre-tax retirement savings plan that lets employees save and invest directly from their salary. Taxes are only paid when the money is withdrawn, which is either during retirement or from an early withdrawal. The plan is sponsored by an employer. It is also known as a traditional 401(k) plan.
These type of plans were started by Congress in 1978. Before that, pension plans were the typical retirement account that was offered by employers. These pension funds generated a steady source of income for the recipient over the course of their retirement. After their introduction, 401k plans were found to be a more lucrative option for the employers than to provide them with a pension. Besides, the resulting compounding interest with delayed taxation of the 401k plan itself is often much more beneficial for employees in the long run.
401k plans are defined contribution plans. That means that the employer and employee together are responsible for the amount of money put into the plan. This is the opposite of pension plans, which are defined benefit plans. A defined benefit plan guarantees a specific payment to a retired employee, whereas a defined contribution plan provides whatever value has been built up from contributions and compounding over the life of the investment. Most employers prefer 401ks because they are easier to account for and can be less expensive. For it is much easier to account for the exact amount of money that is put into a 401k plan versus having to make accruals and account for pension withdrawals that won’t happen for years of even decades, and that have payments that last as long as the employee is alive. The difficult accounting for pensions and the lower cost of 401ks makes the 401k a much better option for the employer. And for the employee, they get more control over how the money is invested, as they can usually choose the funds they wish to invest in. Also, when an employee changes companies, they can transfer their 401k plan to a new employer, or to any broker as a rollover 401k. Through this, the employee has unlimited control and accountability for their own retirement savings. For astute investors, this is almost always a better scenario than relying on your company to invest for your pension plan. Over the long term, many companies change their pension strategies or are involved in mergers or acquisitions that make changes to the pension. Although pensions are governed and insured by the government, they are not guaranteed. If a company goes bankrupt and hasn’t fully funded the pension, the employee is only guaranteed a portion of the pension that they were promised. A 401k, on the other hand, is fully vested shortly after adding the money to your account, and once vested, it cannot be taken away by any company or any bankruptcy proceedings.
401k plans are also more investor-friendly, as they let you control the investment process with the options of mutual funds, stocks, bonds and money market investments. But at the same time, the plans have various restrictions and stipulations. To safeguard the employer from employees leaving very early, you need to serve a minimum period of time to have an access to the money contributed by the company, though you can withdraw your contribution at any time if you want. When it comes to withdrawing money from the plans, a set of complex rules guide the withdrawal process and there are costly penalties for withdrawal of funds before the specified retirement age.
The whole process of setting up, managing and supervising the plans is supervised by an agency that is hired by the employer. Popular companies that do this include Fidelity Investments, T Rowe Price and Charles Schwab. These institutions work as a liason between you and your account and they help guide you through all the updates and necessary paperwork. They also allow online access to your account so that you can easily make changes, shift investments, take out loans against your account, or transfer the account to another broker if you leave the company you work for.
For these plans to be successful, it is very important to use them to the fullest extent. First of all, you should try to match the amount invested by your employer, which is normally up to 3% of your salary. That means if your salary is $60,000, your employer’s contribution will not go beyond $1,800. The rules of matching funds vary, so don’t forget to check with your employer about the details. Almost all the plans offer matching funds – the most popular being 3% of your salary, according to the Profit Sharing/401k Council of America. To get the matched funds from your employer, you typically need to contribute the same ratio of funds as your employer. For example, if your employer will match 3%, then you need to contribute 3% also. So, in effect, you will be adding 3% of your income and your employer will add the same. Some employers, however, match at a 50% rate. In other words, if they offer up to 3% match, you may need to contribute as much as 6% to get the full employer match. Whatever it is that your employer offers, make certain that you take full advantage of their matching policy. After all, this is free money. They are giving you money for your account and all you have to do is add some yourself.
Beyond getting your employer’s match, you should also strive to contribute as much money as your employer or the government allows. If you can contribute up to 10% of your salary, then do it. If your employer allows you to contribute more, then you should also do that. Adding money to your 401k reduces your taxable income and grows tax-free until retirement. It may seem difficult to put that much money into your plan, but to reach retirement, and especially early retirement, you’ll need to make sacrifices in order to ensure that you invest enough money toward your retirement.
There are a number of other 401k plans that you should be aware of. The first one is called a Roth 401k. Roth 401ks, are like 401ks except that the money you add to your Roth 401k is added after tax. However, when you reach retirement and withdraw money from this account, you do not have to pay taxes on any of the withdrawals. That means that using a Roth 401k will help lower your taxable income during retirement. The tradeoff is that you’ll have to pay taxes on the money you add to your account in the year that you make the contribution. This is a small price to pay for the long term tax-free compounding that these accounts offer. Typically, if you have quite a few years before retirement, these types of retirement accounts are much more beneficial and profitable than their traditional counterparts. If you’re wondering how to open an account like this, you have to look to your employer. Many employers offer you a choice between a 401k and a Roth 401k plan, so its up to you to decide which to use. We recommend using the Roth if available.
Another type of 401k plan is the plan for small businesses. If you are self employed, you can start a 401k plan through one of many brokers, like Schwab or Etrade. This works for incorporated businesses that you own and even for sole proprietors. After filling out the paperwork, you make a contribution at the end of each year. For the self employed, these accounts are more flexible. Even though you don’t get a match from anyone, you are allowed to not only contribute a certain percent of your income to the account, but you can make a profit sharing contribution to the account that can be as high as 100% of your adjusted income, up to around $50,000 per year. Basically, using an account like this can shelter a lot of money from taxes. And if you prefer a Roth 401k, you can open a self employed Roth 401k account yourself and make similar contributions.
Overall, the 401k is an extremely valuable tool when it comes to investing for your retirement. If you are offered the chance to participate, make sure you take it.