The 401(k) saving vehicle offers a multitude of benefits to the retiree or the employee saving for retirement. The plan is even more beneficial for young employees starting at their first jobs. Over a long term period the tax advantages of the 401(k) plan becomes more evident and help retire with good amount of funds.
401(k) plans are popularly known for their tax advantage. Generally 401(k) accounts are made up of pre-tax dollars. This means, that tax is not deducted from the amount of contribution the employee makes from his salary to the account.
Also, earnings from the investments made from this account such as dividends, interests or capital gains are not taxed. This translates to maximized earnings from one’s investment and at the same time plays a major part in saving considerable amount of income tax. And since most employees may not withdraw from their plan for decades, the interest and earnings simply keep getting compounded.
Another major benefit of the 401(k) plan is that employers may choose to match a certain percentage to employee’s contribution. This match can be anywhere from 25% to more than 100% of the employee’s investment in the account. A 100% contribution will mean that the employer matches $1 for $1 which can be seen as a 100% return-on-investment. There are hardly any financial products available which promise such gains. Again, tax is not levied on this contribution as well, so it becomes a type of (unofficial) ‘raise’ with tax benefits for the employee. Also, the amount contributed by the employer is not accounted towards the limit of contributions (present $16,500 for age 49 or below, $22,000 for age 50 and above). This means all the more funds for investments, resulting into greater fruitful gains in the future.
When an employee is enrolled for a 401(k) plan, he may be asked by the employer or the plan administrator to allocate some part of the savings to investments. The choice of investment, that is amount to be invested and in what to be invested, solely resides with the employee. This choice helps the employee plan accordingly for their future savings. Younger employees starting their career may choose to invest in high-risk, high-growth funds whereas employees nearing their retirement would want to lower their investments, moving towards liquidity or invest in low-risk areas. In addition to this, the employee can also move their funds depending on the performance of the market.
Rollover or Portability:
One of other benefits that make the 401(k) retirement plan so popular is its portability. This feature of the plan saves a lot of hassle in situations like when one changes employer or changes their retirement plan. An employer charges a fee to the employee for maintaining their 401(k) account. When an employee switches jobs, he/she may or may not have a 401(k) plan with their new employer. Hence an employee may have to pay a maintenance fee to their previous employer regardless if they work there or not. This can tend to set the employee’s finances back if they have multiple accounts. Also, if they withdraw from their plan they will have to pay a penalty charge as well as income tax on the untimely withdrawal. If their new employer does provide them with a 401(k) plan, employees can rollover their previous account into their new one without getting taxed and other hassles.
This portability combined with the tax deferral can be of great advantage if the employee chooses to retire in a state like Florida, Alaska, Nevada, New Hampshire, South Dakota,Tennessee, Texas, Washington and Wyoming which do not have state income tax.
Although mostly advised against, 401(k) accounts can be used for loans or hardship withdrawals. The benefits of such loans are that the funds taken are not taxed. But there is a limit of how much loan one can take on the 401(k) account. Also the funds in the account can be used for hardships limited to buying a first house, paying for higher education, preventing foreclosure or eviction, extreme hardship and tax deductible medical expenses.
Among other benefits of the plan, employees who start saving late for their retirement can contribute more after the age of 50 with additional ‘catch-up’ amount. Also all the 5500 filing, participant reporting, accounting, testing and other details are maintained by the vendor, so the employee does not have to go through mountains of paperwork to keep track of the plan. Such advantages and benefits of the 401(k) plan thus make it a popular and lucrative retirement solution for many.