Updated July 18, 2023
Definition of 401k Plan
The term 401k plan refers to an employer-sponsored retirement plan allowing employees to set aside a certain portion of their salary for long-term investments.
To fund the investments, contributions made by the employer are subject to a certain limit. The amounts contributed to the plan are used for providing retirement benefits to the employees.
401k plans are very popular retirement plans in the US in which the employees and employers contribute amounts to the plan for retirement benefits of the employees. The employees contribute a certain portion of their monthly salaries to the plan subject to an annual limit prescribed by the IRS. The employee can’t withdraw the amounts until the age of retirement, and if anyone wants to make an early withdrawal, they will have to incur a penalty of 10% of the amounts withdrawn.
Features of 401k Plan
Following are some distinguished features of the 401k plan:
- Employer and Employee Contributions: The employees contribute a portion of their salary to the plan within annual limits, while the employers also match these contributions up to a certain extent.
- Tax Deferrals: The contributions made to the plan are not taxed at the time of contribution.
- Withdrawal Restrictions: There are restrictions on withdrawing funds from the plan before reaching a certain age. Participating employees cannot access the funds until they meet the specified age requirement. Early withdrawals lead to a levy of penalties.
- Investment Options: The plan allows the participating employees to choose from a number of investment options for making long-term investments.
How Does it Work?
The employees need to contribute to the plan by deducting from their monthly salaries. The employees are free to decide among the investment options the plan offers and make decisions on their investments.
Who is Eligible for a 401k Plan?
- Age Requirement: An employee must have attained the age of 21 years to be eligible to participate in the plan.
- Service Requirement: An employee must have completed at least one year of service to participate in the plan. However, in the case of a traditional 401k plan, this period might be two years if the benefits are to vest 100% after a maximum period of two
401k Plan Companies
Here is the list of some companies providing services in respect of 401k plans.
- Charles Schwab
- Employee Fiduciary
- American Funds
- Betterment of Business
Advantages of 401k Plan
- Pre-Tax Contributions: The contributions are made on a pre-tax basis, and the same is deferred for taxation purposes.
- Employer Participation: Employers also contribute to the plan for the employees’ retirement benefits subject to IRS limits. The employer might or might not match the entire employee contribution.
- Emergency Withdrawals: If any employee wants to withdraw funds in an emergency situation, then the employee can do so by incurring a certain amount of penalty even before attaining the prescribed retirement age of 59.5.
Disadvantages of 401k Plan
- Penalty on Early Withdrawals: One needs to pay the penalty at the rate of 10% if they want to withdraw the funds before attaining the age of 59.5 years.
- Compulsory Withdrawals: Employees must withdraw all the funds from the plan once they reach the age of 70 years.
- Limited Investment Choices: While the plan offers investment options for employees, the choices available are quite restricted in nature.
401k plans are a good option for retirement plans since the tax benefits help the employees to defer their tax liability. The amounts are only taxed at the retirement age when they are withdrawn. Usually, people have lower taxable income at such an age and thus pay tax at a lower slab rate at such time.
This is a guide to 401k Plan. Here we discuss the definition and how does 401k plan work. along with advantages and disadvantages. You may also have a look at the following articles to learn more –