A 401(k) retirement plan is an employer-sponsored retirement savings program that enables employees to save for retirement by making pre-tax contributions. A 401(k) is the dominant retirement plan scheme that most people in the U.S. will use to provide a decent income once they retire.
Benefits of a 401(k)
Although not perfect, there are benefits of utilizing this type of investment:
- High contribution limits (currently $17,500 per year if 49 years old or younger and up to $23,000 if 50 or older in 2014).
- Income tax benefits include investing with pretax dollars and tax deferred growth on the account until time of distribution.
- Possible employer matching.
- Loans in the event of an emergency or financial crisis.
Challenges of a 401(k)
There are, however, some challenges with a 401(k) plan.
- Most plans have limited flexibility as it relates to quality investment options.
- Fees can be high.
- There can be early withdrawal penalties equal to 10% of the amount withdrawn before age 59 1/2.
In my view, the two biggest issues of a 401(k) plan are that:
- The individual needs to make investment selections themselves
- They need manage their plan over time.
Truth be told, most people are not qualified (nor interested in most cases) to choose such investments or to monitor their plan. I highly recommend that if you are taking part in your company 401(k) plan and are not confident in selecting the investments or monitoring it regularly, that you should seek professional guidance. (Notice the word “professional”. Do not solicit investment advice from co-workers as this often leads to problems.)
Although there are better ways to invest in your retirement, a 401(k) plan for most is an easy way to save for retirement. The money is taken from your paycheck before you have a chance to spend it. If your employer offers a 401(k) plan, sign up for it. A 401(k) is a valuable component of your retirement portfolio that can help you accumulate money for retirement. In addition, investing in a 401(k) is especially beneficial when matching contributions are allowed.
For more information on this topic, we had a lengthy discussion on the Financial Spotlight radio show on whether people invest and manage their 401(k) investments correctly .
Listen to the discussion in two parts:
How do you manage your 401(k) investments? Are you actively managing your investments or are you in the “set it and forget it” category?