401k retirement plans

The 401k plan was set up by the Internal Revenue Service (IRS) in 1978. It allowed for employees of private firms to defer some of their income into a savings plan with many

different investment choices for the saved funds, all within the control of the employee. This is a little more interactive than most traditional or Roth IRAs in that the percentage of funds invested in certain types of investments can be changed periodically and adjusted to more conservative investments as the employee gets closer to retirement. IRAs are generally set up by a broker who will manage much of the movement of the funds.

Employer 401k plans are easy

Most mid-to large sized companies offer their employees an opportunity to save for retirement using pre-tax dollars. These convenient savings plans have many advantages including automatic deposits from payroll checks before taxes are withdrawn which lowers the employee’s taxable income. Another great incentive for saving is that many employers will match employee contributions up to a certain percentage.

Everything you need to know about 401k plans

A quick review of the major 401k guidelines and decisions you will need to make to maximize this powerful tax-deferred retirement plan.

Employer sponsored 401k plans

Employer sponsored 401k plans are managed by a brokerage firm or administrator employed by the company. From there, employees select how much of their income they will defer and how it will be invested. Employers then will often match between 3 and 6 percent of the amount the employee invests, giving the employee a quick and hefty return on their investment immediately. Generally, an employee has to stay with the company at least 5 years to be fully vested for the employers contributions, but their own deposits and earnings are theirs immediately.

Borrowing from your 401K

As with the traditional IRA and Roth IRA, funds withdrawn from a 401k are heavily penalized and taxed if the distribution occurs before age 59 ½. 401k funds cannot be taken out for qualified expenses without penalty as is the case with the IRA, but employees are able to borrow money from their own account. Up to 50 percent of what is in the account can be used for any purpose they deem necessary. The employee will pay the going interest rate on the “loan” but that interest is deposited directly back into their own account. Still, caution should be used in borrowing from one’s 401k account. Should the employee change jobs before the loan is paid off, then they will be required to pay back the remaining balance on the loan and the outstanding interest. If they cannot do that, then a 10 percent penalty on the unpaid portion will be due along with applicable taxes.

Not only are 401k deposits tax-deferred, but the taxes on any earnings are also deferred until they are withdrawn. Chances are good the investor’s tax rate will be lower once they retire, so the taxes will be lower upon withdrawal than they would have been when the investment was made to the 401k.

401k plans have a long investment time horizon

Investments in a 401k plan can grow rapidly depending on the risks an investor is willing to take. Young investors, those between 25 and 45, can generally benefit from investing in the stock market. Those who start investing later or want to protect some of their earnings can choose to place funds in safer types of investments. In general, the earlier an employee can start contributing to their company 401k plan, the better.