In your quest for learning all about personal finances, you will definitely come across this term – 401(k). But what is a 401(k)? Did you ever ask yourself that? If you did, congratulations. You’re my type of guy or girl! You see, I believe it’s best you know these things as early in your life as possible, just so that you can create the best possible future for yourself, from a financial point of view. And I know you do too. Otherwise, you wouldn’t be on my website right now.
So let’s start unraveling the details and see what is a 401(k) exactly, its advantages and disadvantages and whether it’s the right option for you.
The Concept of a 401(k)
The way I would have liked someone to explain it to me back in the day was this. A 401(k) is a retirement plan sponsored by your employer. You can imagine there are a lot more details behind this simple sentence, but I do believe it’s a great starting point. This is, after all, FinancefForDummies.com, right?
Now that I’ve shed some light on what is a 401(k), I can also tell you that its inception dates back to 1978. Since then, it has managed to become the most beloved and popular retirement plan of its type in the New World.
It’s also good for you to know, in short, of course, that there are also a few variations of the 401(k). For example, there’s the SIMPLE 401(k). This is a hybrid between our 401(k) and the SIMPLE IRA. There’s also the safe-harbor 401(k). However, right now, we’re focusing on trying to find out and understand what is a 401(k)?
The concept of the 401(k) itself states the following.
An employee may choose between compensation in cash or deferment of a percentage of that cash into a 401(k) account that has been settled under a plan. All in the name of your retirement, of course.
The amount which you amass over the years will not become taxable until you start withdrawing money from that account. Or until you begin distributing the plan.
Another interesting thing to note here is that an employer is not required to contribute to your plan. You are supposed to do that yourself if you want to have an amount of money to fall back on when you retire or a pension. However, you will discover in the line of work that many employers choose to do so nonetheless. In fact, employers not only contribute, but they match what you, the employee contribute. That happens up to a particular percentage.
The next thing I’m going to tell you about, and you should look into are contribution limits. Like I said above. It’s great to know what is a 401(k), but it does not suffice. Learn its ins and outs for a comfortable and relaxed retirement.
For 2017, for example, the maximum sum of compensation which you, as an employee, can defer into a 401(k) plan has been set to $18,000.
What about if you earn a really high income? First of all, congratulations! Second of all, thanks for coming to my website and reading my articles. Tell a friend! Third of all, yes, the 401(k) might be a problem for you. Let’s say, for example, that you make some $750,000 per annum. Then you can only put in $265,000 as a maximum contribution to the 401(k) plan. However, your employer can always offer you a nonqualified plan, which is the opposite of the 401(k). In this way, you can save some additional money for your retirement.
Advantages and Disadvantages of the 401(k)
Now that you know what is a 401(k), it does sound pretty good, doesn’t it? But are there some dark corners about it that might cast a shadow over your retirement? Let’s see. Here are it’s advantages and disadvantages.
Advantages of the 401(k)
- The Very High Contribution Limit
As I noted above, although there is a limit to it, the annual contribution is very large. It’s $17,000 for an average salary, and it can go up to $265,000 if you’re a high earner. In fact, the 401(k) is among the plans with the highest contributions possible. So, what is the 401(k) from this point of view? A plan that is sure to make your retirement a plentiful one.
- The Employers’ Match
Again, as dutifully reported, most employers will match out your contribution over the years. Not in whole, but to a certain percentage. This is also ideal for you and your retirement plan on the whole. Think of this as free money. The employer is giving it to you besides your salary just for working there.
The limit here is 6 percent of your salary.
- You Can Still Own Other Plans
What is the 401(k)? A lenient and non-restrictive plan that will allow you to have other plans at the same time. If you have enough funds, you can basically invest in as many retirement funds you want apart from the traditional 401(k).
Disadvantages of the 401(k)
- The Forceful Withdrawing
One of the major flaws I’ve found in this plan is this one. It simply compels you to withdraw all your funds when you reach 70 and a half. And you can’t contribute anymore. That might seem like quite a respectable age to settle down and take things easy, right? Well, not really. Think about the fact that the retirement age is slowly increasing and you will understand why this is a flaw in the plan.
- All the Waiting
What is the 401(k)? Something that makes you wait a lot. In the sense that, when you get a job with a new employer you have to wait quite a lengthy period before you can start contributing to your 401(k) again. It’s usually around a year. The period is destined to prove that you will last at that particular job. However, most of us dislike this situation. And understandably so, I might add. We’d like to save as soon as possible.
- You Still Pay Taxes on the Money
It is true, indeed, that you get a break from paying your taxes if and when you contribute to your 401(k). However, that will all be compensated for at the end, when you withdraw the money. The system views the money as a whole and taxes it accordingly. What does that mean? That you could, possibly, be left without a considerable chunk of it.
In the end, just like everything else in the world of finance, the 401(k) too has its ups and downs. The important thing is that you now know what is a 401(k). How about you share your thoughts in the comments section?
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