Apr 03 2011

What is a 401(k) plan?

Category: Finance

Answer:

401(k) PlanA 401(k) plan is a type of defined contribution, savings/investment account that is set up and sponsored by companies to give their employees the ability to set aside money that can be invested for their retirement. Any contributions added to the account will come from the employees (before tax) salary and in many cases the employer will match that amount, up to a certain percentage. Once added to the account, the employee can invest the funds based on their risk/return requirements. Much like a traditional IRA, the main advantage of a 401k plan is that all of the funds and earnings will not be taxed until the account holder starts taking distribution, at which point the money will be taxed as regular income.

401(k) Contribution Limits

Each year the IRS sets the maximum that can be added to a 401(k) plan. In 2010 and 2011, the maximum contribution is $16,500 for individuals under 49. For individuals over 50, the IRS has set up a way for them to catch-up by allowing them to contribute a maximum of $22,000.

401(k) Advantages

A 401(k) plan offers a number of advantages to the participant including:

  • Tax deferred savings and earnings.
  • Possible matching contributions from your employer.
  • A number of investment options – stocks, bonds, CDs, mutual funds.
  • A 401(k) can be rolled over and added to another employer’s qualified plan.
  • Reduction of tax basis or your AGI (adjusted gross income).
  • 401(k) Loans are permitted for qualified reasons.

401(k) Disadvantages

Although, in most cases, the advantages of a 401k outweigh the drawbacks, there are a few disadvantages worth noting. The main disadvantage of a 401(k) plan is liquidity as well as:

  • A penalty of 10% is added to distributions taken before the age of 59 ½.
  • Participants must start taking distributions from the account when they turn 70 ½.
  • A vesting period is often required for matching employer funds.
  • You are often limited to the investment choices your employer offers.

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