It’s wise to make a suitable retirement plan while you are still ahead of yourself. No one knows what kind of trouble lies in front of them in the future. It’s best to be prepared for the troubles that may come in your life. It’s as the saying goes – “Better safe than sorry”. After retirement, no matter who you are the company won’t give a damn about your life or how you’re going to carry out your expenses. So it’s a wise decision to invest in retirement plans from the very beginning of your career. But a common question that may come in one’s mind is that what retirement plans would be perfect for them. In that regard, the 401k retirement plan might be the one you’re looking for. But at first, let’s see what a 401k retirement plan is actually and why you should choose it over the other plans available.
What Is 401k Retirement Plan?
Back in 1978, the IRS established a new provision that allows employees to put some money of their income into an account along with their employers. The 401k retirement plan is put under the sub-section 401k of the Internal Revenue Code, thus its name. The beauty of the retirement plan is that offers employees to cut back their income tax to some extent and in many cases, the employers offer to match your contribution in the account up to a certain percentage. But there are some restrictions too. The primary restriction is that you can’t put more than $16500 in your account in a given year. However if you are more than 50 years old, you get the opportunity to put in an extra $5500 in your account, taking it up to $22000 in any given year. Now let’s look more deeply into the benefits that the 401k offers.
Key Benefits of 401k Retirement Plan
There are 5 key benefits of a 401(k) retirement plans that gives it the lead over other retirement plans. These are –
- Tax advantage
- Employer matching
- Investment customization
- Portability and Roll over
- Loan and hardship withdrawals
- Tax Advantage of 401k Retirement Plan
The main advantage of a 401k retirement plan is that all the money you put in your account is pre-taxed. This means that by putting your money in your 401k account you not only save your money from being taxed at the moment, you also reduce the amount of tax that the government can take from you. Let’s make this a bit clear with an example. Assuming that you’re single and you earn $60,000 a year, you have to pay taxes up to 25% of your income (according to the tax brackets). This means that you have to pay $15,000 in taxes. But if you have a 401k account and you put in $6,000 in the account, that year only recognizes the rest $54,000 in income on that year’s tax return. This means that by putting that $6,000 in your account you are saving $1,500 in tax money, which you would have had to pay otherwise. Also all the money in your account is tax-deferred which gives you the opportunity to not pay taxes on yearly dividends and growths.
Employer Offered Plans
Another amazing benefit of the 401k retirement plan is that in most cases employers offer to match up the deposit made by the employee to a certain percentage. This means that the depending on how much money you can put in your account, the employer gives you a percentage of that money for free. Again, let’s make it clear with a simple example. Let’s say that earn $100,000 in a year and the employer allows you to put 6% of your income into the account. This means that you can put up to $6,000 in your account. Now let’s say that your employer offers 50% matching up on their part. This means that as you deposit $6,000 in your account, the employer also puts in $3,000 in your account for free. Most companies offer matching up on their part to some extent. For example, according to Starbucks’ “Total Pay Package” brochure, the company matches up to 4% of their employee’s income that’s deposited in the account. It also says that anyone who’s been working for 5-10 years in the company would get 75% matching on their deposit. This means that if you earn $50,000 and you put $2000 in your account, the company deposits $1,500 in your account too. However, these plans may vary from company to company, but most companies will offer a matching program up to some percentage. It’s best to analyze the offers as you start building your career.
Investment through your 401(k) Retirement Plan
Another great thing about the 401k is the wide variation of investment plans that it offers. Depending on the size of the company or employer, you could get different numbers of investment options laid out in front of you. Typically the least number of options you may have is 5, but this number could be much higher depending on your employer. The various types of investment plans that the 401k retirement plan offers are briefly discussed for your convenience
Fixed Funds are also known as Guaranteed Funds. These funds are known for sure and steady, predictable growth in long term. These are considered to be very low risk funds as they are guaranteed interest contracts undertaken by large Insurance companies. But the fact that it is of extremely low risk comes with the fact that they offer very little growth.
Mutual Funds are also of relatively low risk. They let small investors to invest their money in various stocks, bonds and other instruments. Almost all 401k investment plans offer at least a few mutual funds to invest in. These funds can be subdivided in to various other categories such as:
1. Bond funds: Invest in government loans, both federal and local. These are taken as low to moderate risk due to the fact that they are very sensitive to change in interest rates.
2. Stock index funds: Consist of stocks of companies and corporations who usually follow the stock market. These are the safest of all the stock mutual funds that you can invest in.
3. Balanced funds: These types of funds mix stocks and bonds. They ensure that you maintain a low risk of investment in stocks while keeping the certainty of benefiting from the bonds.
4. Income and growth funds: These types of investments are thought to be of moderate risks. It is essential for this type of investments to mark out companies that have a well proven record that they pay dividends and still have the chance for fast growth and then invest in their stocks.
5. Aggressive growth funds: This is thought to be of great risk to invest in such funds. This type of investment is made in companies that are relatively new and small and have the potential for a rapid growth over a small period. While these funds may result in large profits in a small amount of time they also run a high risk of losing your money.
6. International funds: If invested in the correct companies, this type of investment has the highest potential for fast growth. For this, you’d have to invest in various companies outside of USA. But these types of investments depend greatly on currency exchange rates, political and economical changes in that country and may contain a great deal of risk.
It’s the simplest type of investment that you could make. But simply investing in stock runs a great deal of risk and thus should be only invested by a small fraction of your overall investments.
Taking a Loan against your 401k Retirement Plan
The 401k investment plan gives you the opportunity to take loans against your account. But once again, it comes at a high price. There are many setbacks of borrowing money from your 401(k) account. Most plans give you the chance to take up to 50% of the money that you deposited as a loan, once you reach a certain limit. Although this seems like a good way to loan some money, there are several key components that you should know at first. The first major drawback is that many plans indicate that you can’t make any deposits until you pay back the loan. Most plans give a maximum of 5 years to pay back. This means that if you take 5 years to repay the loan, you can’t deposit in your account for 5 years. This results in significant reduction in your overall retirement account. Another drawback is that the loans are repaid through deductions in payrolls. This usually means that you get less money to take at home at the end of the month. Also if you somehow fail to repay the loan in time, it counts as an early withdrawal. In the next section we will discuss the demerits of an early withdrawal.
Withdrawing from your 401k investment plan
If you ever need to withdraw money from your account prior to the age of 59½, which is the official age of distribution for a 401k retirement plan, it would lead to some serious drawbacks. You can withdraw money from your account through a hardship withdrawal. These withdrawals offer withdrawal of money from your account while you’re employed only if you can prove that you are in desperate need of money and have exhausted every other option available to you. Usually medical expenses, funeral expenses of a family member or educational expenses are considered as hardship. But it’s up to your employer to determine whether your need qualifies for an early withdrawal. There is another setback in such withdrawals and it’s that the amount you withdraw prior to the age of 59½ is subjected to 10% federal penalty tax and also it is marked as your income and would be subjected to normal tax brackets. Thus the amount you withdraw is charged with both penalty tax and regular tax.