What Is a 401k Plan: The Pros And Cons

So, what is a 401k plan? It's a long-term savings plan which was created in order to help workers save money towards retirement. You decide on an amount that is automatically taken out of your paycheck every week or month, and then it is deposited into the retirement plan on your behalf. You then decide, based on the options the employer gives you, how your retirement plan will invest your money. Your investment options generally include mutual funds, money market accounts, and company stock. What are the Pros? Automatic paycheck withdrawals: It can be difficult to save for retirement, especially if you are young and retirement is a long ways off. Every year your money is put into the 401k plan, is another year it is able to accumulate interest. If you make the decision to automatically have a certain part of your paycheck withdrawn, you don't have to worry about being tempted to spend it. This means you can put a way a considerable amount of money away over time without having to be overly disciplined. Pre-tax advantages: Your contribution happens before the money is treated as income by the IRS, providing you with income tax savings and enhancing the growth of your account. This tax deferred growth can compound over time. Matching Contributions: One of the biggest advantages is that many employers will match employee contributions dollar for dollar. For example, some employers match what an employee sets aside for retirement, up to 6% of their income. Where else are you going to get a return of 100 percent on your money before you start investing. This benefit is significant. Portability: Your contributions to your 401k plan are always "portable". If you leave your job and join another company, you can do one of several things. You can leave the money in the plan if permitted, withdraw it, or roll it over into another 401k plan with your new employer. The IRA rollover is the most popular method, which gives you more flexibility and complete control. In addition, if you have "vested", you can keep your company's matching contributions and move them to the new plan. Borrowing ability: One unique advantage is that most plans allow you to take out a loan from your account for up to $50,000 for five years. Like other loans, you must pay interest, however it is usually only a point or two higher than the prime lending rate. And instead of going to another party, the interest goes back into your account. While it is better to borrow from your plan than to outright withdraw from it, it is better to avoid borrowing from your plan altogether, as that is money that would otherwise be compounding towards your retirement savings. What are the Cons? Early withdrawals are penalized: With certain exceptions, such as in cases of medical hardship, any withdrawals you make before you turn 59 1/2 are considered early withdrawals and subject to a 10% penalty as well as regular income taxes. Loan limitations: Borrowing money from your plan is risky. Should you lose your job, your loan will become due, and if you can't repay the full amount at once, the IRS deems the loan a withdrawal, and in many situations, you will owe income taxes and penalties on the unpaid balance. Vesting: Find out about your plan's "vesting" policy, which refers to the time you must stay with an employer before you can take ownership of an employer's matching contributions. If you leave before you are "vested", you forfeit this money. Understanding just what is a 401k plan is a very important step in planning your retirement. They come with several benefits and limited drawbacks. Consult your HR department for further detail on how you can get started today.