What Is a 401(k) Plan?
A 401(k) plan is a type of savings account that allows employees to save on their own (up to certain limits), and pay lower taxes because all 401(k) accounts are taxed before contributions.
Deductions for these plans are commonly made pre-taxed, while deposits into traditional or Roth IRA’s are deposited post-taxed. 401(k) plans usually make a matching contribution in addition to whatever the employee contributes.
How Does 401(k) Work?
401(k) plans typically provide a selection of investments, including stock and bond mutual funds and money market accounts. Once an employee has opened up a 401(k) account, he or she can decide how to invest the money in his or her 401(k).
The Benefits of Getting a 401(K) Plan
401(k) plans offer benefits to participants. Some employers match 401(k) contributions, which can be a terrific incentive for employees to increase their 401(k) contribution levels.
401(k) Plans Are Tax-Advantaged Accounts
401(k) plans are tax-advantaged accounts because the money that has been contributed is deductible from current income taxes.
Employees can also control how much they contribute to their plans, and the contributions are taxed at the time they are made.
401(k) Plans Encourage Saving for Retirement
401(k) plans encourage people to save more toward their retirement.
The money that is contributed into the accounts can be deducted from an employee’s taxable income, and this helps lower his or her taxable income.
401(k) plans also allow employees to defer investing until their retirement years, rather than having to use their income for investments now.
401(k) May Lower Your Tax Bracket
Some 401(k) plans let you contribute more money into a plan if your taxable income is reduced during the year.
401(k) plans provide you with an option of creating a 401(k) within your 401(k) so that the money you contribute is not subject to taxes.
401(k) Plan Has More Flexible Options for Contributions
401(k) plans are built on certain assumptions, which include that employees are paid twice per month or 24 times per year.
401(k) plans can be adapted to fit an employee’s pay schedule, which means that the participants don’t have to wait for their next paycheck to put money into their accounts.
401(k) participants may contribute as little or as much as they want, and they can divide the contribution over a number of paychecks if they want.
401(k) participants can also specify how much of their contributions go to pre-tax and post-tax accounts, which means that 401(k)s can fit both high and low incomes.
401(k) Plans Give You the Option of Choosing Your Own Investments
401(k) plan participants have the option of choosing 401(k) investments, which means that plans can adapt to any participant.
401(k) plans allow you to change your investments as often as you want within certain guidelines. 401(k) plans also provide more investment options than some other types of retirement plans.
401(k) Plans Can Be a Great Estate Planning Tool
401(k) plans allow participants to treat 401(k)s like wills and leave 401(k) accounts to heirs for tax purposes.
401(k) account balances that pass onto loved ones at death are not taxed. Plan participants can also choose beneficiaries, which helps them provide 401(k) accounts to heirs.
401(k) Plans Offer a Variety of Investment Options
401(k) participants have the option to invest in 401(k)s through different types of investments.
Some 401(k) plans are called matching 401(k)s, 401(k)s with profit-sharing or 401(k)s with 401(k) accounts. 401(k) participants have the option to invest 401(k) money in 401(k) plans through stock and bond mutual funds and money market accounts.
401(k) Plan Allows You to Take Loans From 401(K) Accounts
401(k) participants have the option of taking 401(k) loans, but 401(k) plan loans must be paid back within a set time period.
401(k) plan loan terms vary from plan to plan, and plan participants may borrow money from their accounts to use for almost any purpose. Plan participants can also pay loans back with 401(k) money.
401(k) Plans Encourage Better 401(K) Participation
Employers sometimes require 401(k) contribution levels to be a certain percentage of taxable income, and 401(k)s don’t count 401(k) plans as taxable income.
401(k) participants who are required to contribute a certain percentage of their accounts often don’t have working plans, and plans can help employers increase the participation rates.
401(K) Plans Offer More Investment Options Than Other Types of Retirement Plans
401(k) plan participants have the option of choosing investments, which means that 401(k) plans can adapt to any participant.
401(k) plans allow you to change investments as often participants want within the account guidelines. Participants also have the option of choosing investment options like stock and bond mutual funds and money market accounts.
The Bottom Line
Storing money in a 401(k) plan is an excellent approach to prepare for your retirement years.
401(k) plans allow participants to contribute money at any time and allow the participants to change 401(k) account investments easily.
401(k) plans offer contributors more investment options than some other types of retirement accounts, and these plans can be a great estate planning tool. 401(k) plans also encourage 401(k) participation because participants can take loans if they want.
These are just some of the benefits you can enjoy with a 401(k) plan.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.