Retirement savings: What is a 401(k) plan?

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How does a 401(k) work? What are the benefits of having a 401(k) plan? Learn more about the 401(k) to see if it should be a part of your retirement plan.

Of all the various retirement investment options available to workers, the 401(k) is probably the most well-known. The 401(k) plan, named for the section of the Internal Revenue Code which authorized the use of the plan in 1978, is a retirement plan offered through an employer. These plans gained popularity among employers in the 1980s as an alternative to pensions and are equally popular with employees thanks to their portability, employer matching contributions, and increased control over how money is invested.

How does a 401(k) work?

Contributions are automatically deducted—before tax—from an employee’s paycheck, which makes it one of the easiest ways to increase your retirement savings. Employees select the percentage of pay they want deducted from each paycheck and funds are automatically deposited into the employee’s 401(k) plan. Account holders are able to choose from a range of investment options within the 401(k), which are composed of stocks, bonds, and money market investments.

401(k) retirement plan advantages

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401(k) retirement plans have several benefits. One of the biggest is free money, which comes in the form of an employer match. While not required to do so, employers often offer a “match” of employee dollars up to a certain percentage. For example, your company may offer to match your retirement investment dollar for dollar up to 3 percent, or to invest 50 cents for every dollar you contribute up to 6 percent. While both contributions equal the same amount for the same employee, the latter forces the employee to invest up to 6 percent to receive the full match. Because a higher percentage is being invested, retirement savings will grow faster.

Another advantage of the 401(k) retirement plan is having more control over how your money is invested. Your company will offer a number of retirement investment options that you can select from to best suit your retirement plan and investment strategy. The most popular options tend to be a combination of stocks and bonds that gradually become more conservative as you reach retirement age.

401(k) retirement plans have several other benefits as well, including:

  • High contribution levels. You can contribute up to 16,500 (for 2010). (Those 50 and over are able to make an additional contribution of $5,500 in 2010.)
  • Portability. If you change jobs or if your company should go under, your plan is still available and yours to take with you. A 401(k) rollover enables you to move your 401(k) plan to a new employer’s plan or to a traditional IRA.
  • Retirement funds grow tax-free. Any money you invest in your 401(k) retirement plan and any gains made on that money compounds tax-free.
  • The ability to borrow from your 401(k) plan. You may take a loan on your 401(k) account or receive economic hardship distributions. An economic hardship can include medical care expenses, tuition expenses, and other immediate and large financial needs. However, you may face taxes and will be required to repay the loan.

401(k) retirement plan restrictions

While the 401(k) plan offers many advantages, it does face some restrictions. Depending on your company, you may not be able to contribute to your employer’s 401(k) until you’re “vested”—meaning you are required to work for the company for a set period of time before you can contribute. Or, you may be able to contribute right away, but your employer match won’t kick in until you’ve completed your vesting period.

In addition, your 401(k) retirement savings aren’t tax-free—simply tax-deferred. You will have to pay taxes on any funds you withdraw after you retire. And if you withdraw funds from your plan before age 59½ you could face a 10 percent penalty on top of regular taxes.

And even though the contribution levels for 401(k) retirement plans are much higher than other retirement investment options, some may still see the contribution limits as a restriction.

Should I invest in a 401(k) retirement plan?

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401(k) plans are a good investment as part of your overall retirement savings. If your company offers a 401(k) retirement plan, take advantage by at least investing enough to get the full matching amount your company offers.

Have you started your retirement planning yet? Start the retirement process now and learn more about how much you need to save for retirement, how to increase your retirement savings, and other retirement investment options.

This article contains general information. Individual financial situations are unique; please, consult your financial advisor or tax attorney before utilizing any of the information contained in this article.

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Source: Wall Street Journal, 401khelpcenter.com, FiLife.com, IRS.gov
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