A 401K retirement plan is a wonderful benefit for employees. It provides tax advantages, investment flexibility, and the opportunity to save for future retirement. How 401K retirement plans work, and the benefits of participating in a 401K plan, will be discussed.
401K Plan Overview
401K plans are company sponsored retirement plans. When a company offers a 401K plan, a list of funds, such as stocks, bonds, or mutual funds will be provided. The employee must choose a percentage of their pay to invest and then choose, based on his or her investment risk tolerance, which funds to invest in. Employees will be given a name, number, and/or website address of the managing investment company so that they can get help in choosing the proper investments.
Once the contribution percentage and funds have been chosen, the “employee contribution will automatically be deducted” (McKinney, 2006), before taxes are withheld, from each pay check. The employee contribution is then invested in the funds the employee chose.
Often, companies that sponsor 401K plans provide the added benefit of matching a percentage of employee contributions. The matched contributions are also invested in the funds the employee chose.
All money invested in the funds will grow at that particular funds rate. The money can be withdrawn when the employee reaches the age of 59 ½. It is possible to withdraw the funds before the age of 59 ½, but that is only recommended in times of serious hardship, because early withdrawals “usually require a penalty along with payment of taxes” (McKinney, 2006).
There are several benefits to 401K plans, which are outlined below:
1. It simplifies saving by automatically deducting the contribution from the pay check.
2. Contributions are made pre-tax, which may put the employee in a lower tax bracket.
3. Investment earnings are not subject to income tax until the time of withdrawal, which can result in considerable tax savings.
4. Employer matching increases the contribution amount and the potential earnings.
Employer matching, combined with the tax savings, can increase an employee’s retirement fund considerably. Dustin Woodard provides a wonderful example of the benefit of employer matching in his article Maximize 401(k) matching:
“When an employer offers 401k matching, they are guaranteeing that they will match a certain percentage of your contributions. A common match is 50 cents on the dollar. That means if you put one dollar into your 401k plan, they will match your contribution by putting 50 cents in. You just made 50% on your investment!” (2006)
McKinney, J. (2006). “About 401k Plans.” About.com website. URL: http://poweryears.about.com/Od/finances/a/401k.htm
Woodard, D. (2006). “Maximize 401(k) Matching.” About.com website. URL: http://mutualfunds.About.com/cs/retirement/a/matching.htm