401(k) is qualified plan established by employers to which eligible employees may make salary deferral (salary reduction) contributions on a post-tax and/or pretax basis. Employers , on their part, may make matching or non-elective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis.
Why should I be aware of this?
As most Americans today are living longer, healthier lives, their finances also need to accommodate the extra years of retirement. Social Security alone does not provide as much as one was earning before retirement. That’s where a 401(k) comes in.
All about 401(k) Plan
The 401(k) plan became popular in the 1980s for companies to offer their employees retirement benefits without taking on the liability of a fully-funded pension plan. Employees set aside a part of their pre-tax income and employers typically matched some percentage of those contributions. Employees chose where the money would get invested, out of the offers given by their employers. The scheme ran successfully, especially during the dotcom boom of 1999.
Benefits of 401(k) plan
- An employee’s and employer’s contributions, and any earnings on 401(k) account are not taxed until they are withdrawn. Consequently, the employee’s account balance may grow more quickly.
- The amount you contribute to the Plan gets reduced from your income, placing you in a lower tax bracket. This also means you have more money in your account working for you. Contributions are subject to Social Security and Medicare taxes.
- Automatic payroll deductions make saving for retirement easy. You’re less likely to miss money you never see.
- Unlike traditional pension plans, 401(k) plans offer participants the option to choose how to invest their contributions.
- Being a “portable” plan, you can have the option of rolling your 401(k) money over into an IRA (Individual Retirement Account) or a new employer’s plan or withdrawing the money in case you are not working with your current employer.
- You have the option to borrow from your account. Many plans have loan features that let you withdraw money (without taxes or penalties) as a “loan to yourself. You may be able to pay the loan back automatically through payroll deduction, and the loan interest goes into your own account, too.
- Your employer may contribute “matching” funds on a portion of your savings. If so, you reap an instant benefit from contributing to your plan.
There are a number of investment options under 401(k) plans offer a number of investment options for your money. It is up to you to avail of the options, which may be putting your money in just one of them or dividing your contributions among various options. Among the possibilities that may be available to you are the following:
- Stable value funds
These funds, also called “Fixed Fund” or “Guaranteed Fund,” provide consistent, predictable growth over the long term and are backed by contracts issued by insurance companies, such as “Guaranteed Interest Contracts” or “GICs.”
- Company stock
You can acquire an ownership interest in the company by selecting your employer’s stock, Ideally this should be a small portion of your investment as buying the stock of any single company—including your employer, carries a very high degree of risk.
- Mutual Funds
Mutual funds options pool money from many investors and can invest it in various securities such as stocks, bonds and money market instruments. Among the types of accounts that may be available to you in your 401(k) plan are:
In the lowest rung of the risk ladder are money market mutual funds assets consisting of U.S. Treasury bills, Certificates of Deposit (CDs) and other commercial investments. Returns on these investments are also lowest and they get affected by inflation.
Bond mutual funds typically invest in government or corporate bonds, or a combination of both. Government bond mutual funds can invest in U.S. Government, state government, or local government bonds. Corporate bond mutual funds invest in a variety of bonds from companies across the country or around the world.
Stock mutual funds, which are usually invested in various publicly traded stocks, can rise or fall quickly in value over the short term. While past performance is not a guarantee of future results, historically stocks have performed better over the long term than other types of investments (e.g., government bonds, treasury securities). Stock prices fluctuate for a wide range of reasons, and stock mutual funds are subject to the same market risk as stocks.
Growth mutual funds invest in companies that have better-than-average growth potential over time. These investments span a broad range of industries, and may or may not pay dividends. Growth funds are considered higher risk, so expect significant fluctuation in share price.
Index mutual funds reflect the performance of stock market indexes, such as the Dow Jones Industrial Average or the Standard & Poor’s 500 Composite Stock Price Index (S&P 500). They do this by investing in all (or a representative sample) of the companies included in the index. Index mutual fund investment reduces the risk that the fund portfolio will be subject to poor investment decisions.
Income mutual funds invest in stocks that have a history of paying regular dividends. These investments tend to fall in the middle of the risk spectrum for stock mutual funds.
Growth and income mutual funds generally invest in companies believed to have growth potential and a solid dividend payment record. They’re designed to help you hedge your bets— even if the share price falls, dividends may offset the loss. Growth and income fall in the middle of the risk spectrum for stock mutual funds.
Aggressive Growth mutual fund portfolios include stocks of start-up companies, smaller businesses or firms in high-risk industries. These stocks may be volatile and should be purchased by those with a higher risk tolerance.
What can I do?
- To participate in a 401(k) plan, you must be an employee of a company that sponsors such a plan for its workers.
- To initiate a 401(k) you’ll need to follow a three-step process:
- Fill out the paperwork or online sign-up forms provided by your employer.
- Plan to attend the orientation sessions or
- Read the orientation material provided by your employer so you can fully understand how 401(k) plans work.
- Find out as much about the plan as possible
- If you were unhappy with the investment choices at your last job, you may find better ones at a new job, even if both plans are offered by the same provider.
- How much of your income to set aside each payday is your decision. As your employer may match your contributions, it’s a good idea to contribute at least as much as your employer will match; otherwise, you’re leaving free money behind.
- Finally, you must choose the specific investments you’ll use to help pursue your goal of accumulating money for retirement.
So many small businesses are offering 401(k) plans to employees that they're becoming regarded as not a perk but part of the standard package, like health insurance or paid vacation. Small businesses that make no provision for employees' retirement options aren't likely to retain top talent for long.
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