The 401(k) plan is the most popular and most commonly utilized employer-sponsored retirement savings plan in the United States of America. Millions of people use a 401(k) account to save money for their retirement years.
The plans are implemented by employers, allowing those employers to distribute company stock to employees and receive benefits such as tax breaks as well. If you participate in a 401(k) you will also receive certain benefits depending on the plan and its specific regulations. The most common benefits include receiving employer-matched contributions and certain tax breaks among other things. For more information about 401(k) plans, their risks and benefits, read the sections below.
What is a 401(k) Plan?
A 401(k) plan is an optional arrangement that allows you, as an employee of a company that has a 401(k) plan established, to defer a percentage of your pay into a retirement account. In most plans, the money transported from your earnings is done before the earnings are taxed. Therefore, you receive a tax benefit, among other benefits, when using a 401(k).
Although 401(k) plans are administered through various companies that work closely with employers, the 401(k) is a retirement plan that is known as a qualified plan. Qualified plans are governed by the regulations stated in the tax code and the Employee Retirement Income Security Act of 1974. This means that the federal government regulates the plans and some plans are subject to certain nondiscrimination requirements that assess whether contributions are being provided fairly.
Benefits of 401(k) Plans
- Lower taxable income
In most 401(k) plans there is the benefit of having a lower taxable income when tax season rolls around. This is because the plan accounts for money that you contribute into your plan and deducts that from your taxable income. This in turn results in a reduction in the amount of money you must pay in taxes each year. This is an incentive to contribute more earnings to your 401(k) account in order to receive a larger tax break while also becoming more prepared for retirement.
- Pre-tax dollar contributions
Another tax benefit of utilizing a 401(k) plan is that for most all plans, the money you contribute to the account is sent to your 401(k) before taxes are deducted. This means that the money paid is considered pre-taxed. The benefit of having pre-tax dollars contributed to your plan is that you end up paying less money to taxes because that portion is not taxed at all. For example, if you opt to contribute 5 percent of your earnings into your 401(k), instead of paying taxes on all 100 percent of your earnings, you will only pay taxes on 95 percent because the money placed into your retirement account is not taxed.
This tax break may even make up for the amount of money contributed in some cases. As an example, you could increase your contributions by one percent and it is likely that you will not notice much of a change in your paychecks because less taxes are withheld. However, you should note that taxes will need to be paid eventually, likely when you retire and start withdrawing the funds.
- Company contribution match
One of the biggest benefits for utilizing a 401(k) account for your retirement is employer matching. In some plans, an employer will contribute a certain amount of money to your account based on the amount that you contribute. The terms vary quite a bit with some rare cases of employers opting to match contributions dollar for dollar while others match 50 percent or less of contributions or others do not match your contributions at all.
There are employer contribution limits that may change each year, and there may also be stipulations in place where the employer will only contribute once you have been fully vested. Being “fully vested” means that you have met certain requirements, usually having to work at the company for a certain period of time, before the employer will match contributions.
- Lifetime contributions
Some retirement plans require you to stop contributing to your plan once you reach the age of 70 years and 6 months old even if you are still working. They also may require that certain distributions or withdrawals are taken from the account. 401(k) plans allow you to continue contributing no matter what your age is as long as you are still working, and you do not need to take required minimum distributions (RMDs) from the account.
Risks of 401(k) Plans
The 401(k) plan does hold a certain level of risk because 401(k) payouts depend on investment performance. As with any investment opportunity, there is always the chance that will you lose a portion of your retirement funds. However, there is also the chance that you end up gaining money on your investments.
These risks can be minimized through careful and strategic planning. One strategy for maximizing your 401(k) payouts is to diversify your portfolio. This means that you should ensure that you have a variety of different asset types in your portfolio, including stocks, bonds and more.
Some types of assets carry more risk than others. For example, international investments are riskier than investing into bonds. You are able to choose what your portfolio consists of, and the level of risk you take with your investments is completely up to you unless you would rather trust a professional to manage it. If you opt to manage your own account, it is important to carefully consider what level of risk you are willing to take with certain investments based on how soon you will retire and how much income you are able to contribute.
Tips for Your 401(k) Plan
If you opt to participate in a 401(k) plan it is very important to ensure that you are educated on what the 401(k) plan consists of. There are many different types of plans, and there are also many different regulations associated with certain plans that you should be aware of. A large component of having a 401(k) plan that successfully provides for your retirement is being knowledgeable about your 401(k) plan and managing it well. Once you are aware of the risks and the benefits associated with that type of retirement plan, you are more likely to take advantage of those benefits.