Section 26 U.S.C. § 401(k) of the Internal Revenue Code (of 1987) makes provision for a retirement savings plan for employees which allows them to plan and save for their retirement. The plan makes such provisions that employees can have their savings invested while deferring income tax on the savings and the gains/earning till the time of withdrawal. The plan is thus known for the section of its provision, i.e. 401(k).
Retirement plans sponsored by employers are generally of two categories, defined benefit (DB) and defined contributions (DC). The 401(k) plan falls in the DC category where the employee contributions are directly deducted
from their salary and deposited in a 401(k) account that is created by the employer for the particular employee where the amount to be contributed to the plan is solely at the employee’s decision. The employer may often choose to match the employee’s contribution to the plan. However it is not mandatory for the employer to do so.
A major advantage of the 401(k) plan is that generally the contributions are deducted before the employee’s pay is taxed, which means that the savings (principal amount) in the 401(k) account are made up of pretax dollars. The 401(k) plan is set up by the employer for the employee and generally the employees cannot start contributing to the plan till they finish one year with the company/employer. When the employees do start contributing to the 401(k) account they are asked to allocate some or all the funds into different kinds of investment funds like stocks, bonds, mutual funds etc. As investments grow in the 401(k) account, the employees do not pay tax on the earnings from them (like capital gains, dividends and interests) as well. Taxes are levied directly on the amount withdrawn from the account.
Withdrawals from a 401(k) account do have their rules and limitations as well. Untimely withdrawals or withdrawals that do not fall in line with the ‘exceptions’ will incur penalties (usually 10%) from the 401(k) administrator. Also when one reaches a certain age (70 ½), minimum distributed withdrawals become compulsory and not taking them also incurs a penalty.
Apart from the tax deferral benefit the plan offers, another lucrative advantage of the 401(k) plan is that the companies offer to match a certain percentage to the employee’s contribution to the plan. The companies use this tactic to entice people to start saving for their retirement and mostly match 10% to employee’s contribution. Some even use this factor as a tactic for hiring and retaining employees by offering a lucrative match as high as 150% of employee contribution. This contribution appears just like a raise, albeit not in the pay package and not on the pay-slip.
There are various types of 401(k) plans are offered by and mostly maintained by the employer, they may differ from company to company. If one leaves their company and joins another, they can rollover their previous 401(k) account in the current 401(k) account with the new employer or they can choose to let their account be with the previous employer (in cases like where the current employer doesn’t offer a 401(k) plan). Should one choose to let the account be with their previous employer, that employer may, and they mostly do, charge the person an account maintenance fee.
One also has to monitor the funds in their 401(k) account to know where the money is invested and observe its growth. Having all the funds invested in one place or in their own company can tend to be a high risk factor. Younger employees may choose to invest in high risk-high growth sectors in their initial years of working and on the contrary, employees nearing their retirement will want safer investments. Hence, one should check with their opening balance and their current balance to confirm if the growth is moving in the direction they planned for. Also if there has been an untimely withdrawal from the 401(k) account one should be careful while filing taxes. If one finds it difficult to file the taxes or encounters other problems after such withdrawal, they can always consider hiring a tax lawyer who can take care of all the issues.
All these factors like portability, tax deferral, investments and matching contributions make the 401(k) plan an ideal one for saving for retirement. Hence it has been proven as the most popular choice among employees.
