What is a 401(k) Plan?
A 401(k) plan is a retirement savings plan that is funded by employee contributions with matching contributions from the employer. The major attraction of these plans is that they are taken from pre-tax salary, and the funds grow tax-free until withdrawn.
Advantages of 401(k) Plans
Following are advantages of 401(k) plans:
- Since the employee is allowed to contribute to his/her 401(k) with pre-tax money, it reduces the amount of tax paid out of each paycheck.
- All employer contributions and any growth in the capital grow tax-free until withdrawal. There is a compounding effect of consistent periodic contributions which is quite dramatic over a 20- or 30-year period.
- The employee can decide where to direct future contributions and/or current savings, giving much control over the investments to the employee.
- If your company matches yours, it’s like getting extra money on top of your salary.
- Unlike a pension, all contributions can be moved from one company’s plan to the next company’s plan (or to an IRA) if a participant changes jobs.
- Since the program is a personal investment program for your retirement, it is protected by pension (ERISA) laws. This includes the additional protection of the funds from garnishment or attachment by creditors or assigned to anyone else, except in the case of domestic relations court cases dealing with divorce decree or child support orders.
- While the 401(k) is similar in nature to an IRA, an IRA won’t enjoy any matching company contributions, and personal IRA ones are subject to much lower limits.
Disadvantages of 401(k) Plans
Following are disadvantages of 401(k) plans:
- It is difficult and expensive to access your 401(k) savings before age 59 1/2.
- 401(k) plans don’t have the luxury of being insured by the Pension Benefit Guaranty Corporation (PBGC).
- Employer matching them are usually not vested (i.e., do not become the property of the employee) until a number of years have passed. The rules say that employer matching contributions must vest according to one of two schedules, either a 3-year “cliff” plan (100% after 3 years) or a 6-year “graded” plan (20% per year in years 2 through 6).
401(k) plans have proven to be popular with employees for several reasons, being the tax deferral, the increased portability of this plan, employer matching contributions, and the increased control associated with self-direction of investments.