Exploring 401(k) Plans -- Chapter 1

Chapter 1

Introducing The Basics of 401(k)

401(k)s had their birth in 1981. These plans have consequently made saving for retirement particularly easy. The 401(k) plan requires that money is deducted from an employee’s weekly salary and subsequently put into the employee’s retirement plan. There is no doubt that 401(k) plans have grown in popularity since 1981 but in recent years the momentum was caused the traditional defined benefit pension plans to be gradually displaced.

Typically, this employee must show that he or she has worked at the company for a specified amount of time before being allowed to participate. Another stipulation may be that the employee has to work a specific number of hours one per week. Now, once an employee is in the 401(k) plan, he or she can contribute up to a specified amount annually. One of the key benefits of a 401(k) plan is that the employer, many times, will match a certain percentage of an employee’s contribution. The employer may contribute as much as 50% of each dollar. The employee can view this as free money being deposited in his or her investment account.

A Number of Investment Options

Within the plan, the individual will be able to choose from a number of investment options. A 401(k) plan generally provides a variety of fund choices for the investor to choose from. An individual has the option to make changes in the amount which he or she contributes and also has the choice of where the money is invested within the plan. As with almost any other investment plan, an individual needs to carefully plan the asset allocation and to always consider diversification.

All employees are concerned about taxable income so he or she should know that a 401(k) also helps to reduce the gross taxable income. The manner in which gross taxable income is reduced is that contributions are deducted from the employee’s pay before the taxes are withheld. The employee can also save money because of the tax-deferred growth. This means that the money in the plan will compound without being annually taxed.

A 401(k) plan was named one particular section of the federal tax code. The 401(k) plan has similarities to the Individual Retirement Account (IRA). One of the similarities is that both the 401(k) plan and the IRA plan are designed as a retirement savings plans, first and foremost. A defining characteristic of 401(k)s is that all employee contributions, employer contributions and any even the growth in the 401(k) is tax-deferred until the money is withdrawn.

However, a stipulation which some may find restrictive is that after the money is in a 401(k), the employee generally cannot make withdrawals before he or she has attained the age of 59½. There may be some special circumstances where this restriction can be lifted. If an employer includes a loan provisions in the plan, then the employee has different options.

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