Retirement Basics: 401K
Employee retirement plans have gone through a huge change in the past few years. A few decades ago, there were no retirement plans in place. Instead, there were pension plans. This meant that the employer would pay a certain amount of income to their employees in their old age till the day they or their spouse were alive. This type of plan was called the defined benefit plan, wherein the employer was supposed to provide their employee with agreed-upon benefits.
However, it is important to note that life expectancy was very short at that time. Very few people lived to see even their sixties. This is the reason that the employers could afford to pay a pension. However, with the advancement in science, life expectancy went up. As a result, the amount of money being spent on pension also started going up. In order to reduce this amount being spent on pension, a new type of retirement plan was thought of.
This relatively new type of retirement plan is called a defined contribution plan. This is because, as per this plan, the employers obligation ends when they make a contribution to the plan. The amount of money received by the employee may be more or less depending upon external factors. 401(k) is a type of defined contribution plan. It is the most widely used investment vehicle across the United States for retirement planning.
In this article, we will have a closer look at how 401(k) works.
What is a 401K Plan?
As mentioned above, the 401(k) plan is a plan which is created to ensure that employees have enough money during their retirement years. Since this plan is meant for the retirement years, the most important thing is that the withdrawal of money is restricted. Hence, in an average mutual fund, you can invest your money or take it out at will. However, when it comes to 401(k), there is a penalty on withdrawing the funds before reaching the age of 59 years and six months.
The plan takes its name from section 401(k) of the Internal Revenue Services act, which makes special provisions and allows tax breaks for people who want to save for their retirement. The government wants people to be able to fund their own retirement. This is because if they are not able to do so, then the government has to partially take care of some of these people in their old age.
Benefits of 401K Plans
401(k) plans have several benefits. Some of these benefits have been explained in this article.
- Tax Deferral: The most important part of the 401(k) plan is that it allows the person to grow their savings in a tax-deferred manner. The government has set up a certain limit for investment in 401(k) plans. The limit nowadays hovers close to around $19000. This means that an employee can reduce their income by up to $19000 if they invest the same in 401(k).
For instance, if a person has an income of $60000, they can invest $19000 in 401(k) and only pay tax on the balance of $41000.
In countries like the United States, the effective tax rate is about 25%. Hence, by investing in 401(k), a person is able to reduce their tax outflow by this amount.
The investments continue to grow tax-free for many years. Finally, when the withdrawal is made, the income tax is charged only on the amount withdrawn. Hence, a person can defer tax for a long time if they do not want to withdraw the funds in their account.
- Automatic Savings: The 401(k) is a system using which money can be deducted from the employees salary before they have access to it. This helps employees pay themselves first, which is a very important concept in personal finance. When employees get their salary, this amount has already gone to the retirement account. This forced savings helps protect this money from impulsive purchases and ends up increasing the net worth of the investor in the long run.
- Matching: Lastly, the biggest benefit of the 401(k) plan is matching. Matching is a concept using which employers also contribute to their defined contribution to the plan. Most employers set up certain limits for matching. For instance, they may match 100% of the contribution till 3% of the salary and then 50% of the contribution for another 3%. This means that if a person receives $50,000 and they invest $1500 in their 401(k), the employer also invests $1500, and the amount is doubled. Similarly, if the invest another $1500, this time the employer puts in $750. Hence, if an investor puts in $3000, a total of $5250 reaches their account. The matching concept helps almost double the employee contributions. This helps employees build wealth fast and is one of the main reasons behind the popularity of the 401(k) plan.
Disadvantages of 401K Plans
There are some disadvantages of 401(k) plans as well. They have been listed below:
- Restrictions on Investments: There are relatively fewer options available in order to invest funds that are in a 401(k) account. This is largely because of government regulations. The government does not allow too much investment in employer stock or certain other risky assets.
- Higher Taxes: The 401(k) plan does not waive off taxes. It only defers them. Hence, when a person retires later on in their life, they tend to have a higher income. As a result, their income tends to fall in a higher tax bracket. The end result is that they owe more money in the form of taxes since they fall in a higher tax bracket.
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