All About 401k Plans

A 401k is a retirement savings plan established by employers. These plans provide a wide array of benefits such as tax advantages and automatic savings. Not all employers offer this option but if yours does, you’d be wise to take advantage of it.

Ultimately these plans are dictated by the IRS. However each company has a certain amount of freedom to move within the guidelines. This means that every company’s plan will vary somewhat.

If your employer offers a 401k plan, talk with your company’s benefits department. They can help explain the specific rules for their plan.

Pre-Tax Contributions

One of the major advantages of these plans is they allow you to make contributions with pre-tax dollars. This reduces the amount of income that’s taxed, therefore saving you money.

There are limits to the amount of your gross salary that can be contributed each pay period. However, these limits vary by company and will also change if you’re considered a highly compensated employee. Again your benefits department can let you know their limits.

Probably the best thing about a 401k is that some companies match a portion or even all of your contribution. Please take advantage of this if it’s offered since this is free money to you. Let’s say you invest $100 per month and your company matches 50% of contributions. Your monthly contribution amount would now be $150.

Your Money Grows Tax Free

Another major perk is that the money in your 401k plan grows tax free until withdrawn. This is huge when you consider you’ll likely contribute to your plan for a long time, usually somewhere between 10 and 40 years.

Obviously the earlier you start the better. However, most plans allow for catch-up contributions when you’re over 50. You can also choose to make after-tax contributions to your plan if you feel you need to. This raises the limits on how much you can invest and since this money is taxed upfront you won’t be taxed again when it’s withdrawn at retirement.

These Plans Are Mobile

Another great thing about these plans is that they can move with you. If you change jobs, you can rollover your 401k from the old company to your new one. Your best option in doing this is to opt for a direct rollover. This means the money goes directly from your old company’s plan to the new company’s plan. You never touch it.

The alternative is to have the check sent to you. You would then be required to deposit the money into your new account within a certain number days. The problem with this method is you’ll be taxed heavily (20% in most cases) and required to replace 100% of the amount taken out of the old account or face further taxes and penalties.

Talk with your benefits department to get a clearer picture of the implications before requesting a check.

If your new company doesn’t offer a 401k plan you still have options. You can rollover the money into an IRA and keep all the tax benefits. Just opt for a direct rollover in this case as well.

You Have Access To Your Money

Another cool thing about these plans is that they allow limited, penalty-free access to your money before age 59 ½. You can actually take a loan from your plan. This works like most other loans in that you make regular payments and pay interest on the amount borrowed. The difference is you pay yourself back instead of a bank.

Although this can come in handy in the event of an emergency it’s usually not a good idea to mess with retirement plans. Your money can’t grow and compound if it’s not in the account. But it’s nice to know it’s there if you absolutely have no other options.

You Have Investment Options

Most companies also offer a nice menu of investment options for these plans. These are mostly mutual funds which usually include a money market fund, bond funds of varying maturities and stock funds. You can choose how to arrange your investments based on your risk tolerance.

Obviously the farther from retirement you are the more risk you can legitimately take. Remember more risk equals a greater potential for reward. You can do this because you have more time to recover should the market take a nose dive. Conversely the closer you get to retirement the more you’ll want to transition into lower risk bonds that help preserve capital.

401k plans are excellent because you’re investing small amounts on a regular basis. Employers deduct the amount you set from your paycheck each pay period and automatically invest it based on your specifications.

There are also plans available for the self employed. They're called individual 401k plans and work much the same way.

This type of investing negates a lot of the market swing since you’re constantly buying whether the market is high or low. The averages over the long term will almost always work in your favor.

So in short, if you have the option of investing in a 401k plan, do it. Learn all you can about your company's plan and take advantage of one of the best gifts you’ll ever receive from the IRS.

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