Understanding 401(k) Plans and Their Benefits

 

The 401(k) plan allows workers in the United States to save for retirement through automatic payroll deduction. The primary benefit of the 401(k) plan is that the money is invested before income taxes are deducted so the entire total is invested instead of the total minus taxes that would be invested outside of a 401(k) plan. Income taxes must eventually be paid on the original investment and any accrued interest or growth but only upon withdrawal. What makes this income tax deferment an especially good deal for most investors is that they’re typically going to be in a higher tax bracket during their working years when they’re contributing to the 401(k) plan then they will be in their retirement years when they’re making withdrawals.

As an employee benefit, many employers also choose to match all or part of an employee’s 401(k) contribution. This match is often in company stock but the employee can subsequently reallocate the investment as he or she chooses. In fact, many large employers are moving from funding pension plans and their substantial and often hard to account for future costs to matching 401(k) contributions instead. The employee gets greater control over their retirement investments and the employer reduces costs while offering a benefit that most employees value.

401(k) funds can also, under certain circumstances, be withdrawn to help pay for certain qualified expenses. In effect, these withdrawals are a loan of 401(k) assets of an employee to himself or herself that will then be repaid through payroll deduction just like the 401(k) account was originally funded. These loans are not without cost, though. Because these accounts are meant to be used as a vehicle to save for retirement there’s a 10% penalty based on the amount withdrawn and income tax must also be paid on the balance withdrawn as well.

401(k) plans are a great way to save for retirement but aren’t always the best option for retirement savings. Depending on employer match policies and the types of investments available in the plan, it may make more sense to forsake the tax benefit of the 401(k) and invest all or a portion of retirement savings in Individual Retirement Accounts (IRA) accounts or other investments like real estate or commodities.

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