Overview
The 401K was originally developed as a
supplement to a company pension plan. It was set up by the government as
a way to allow people to save money for retirement and is named for the
tax code that governs it. To encourage participation across the board,
the federal government offers special tax advantages for contributors.
Employees are allowed to invest their pretax earnings and taxes are paid
only when the money is taken out of the account. The 401K is a great
tool for retaining quality employees.
How it Works
To set up a 401k through your employer, you designate a percentage of your income to go directly into the account each time you receive your salary. You have the option to decide your investment size.Employee contributions to a 401K account are matched by the company. The company may either choose to match the employee's contribution either on a dollar to dollar basis or on a percentage of the employee's investment. But the latter is usually the norm.
While an employee will have access to their own contributions, they may not have access to the contributions made by the company until they are fully vested with the investment, which is usually the maturity period. This period of investment is determined by the company as a way of retaining employees.
Normally, a company hires an external investment firm to manage the 401K plan, which provides regular updates about the plan and its performance. They manage all paperwork and send you the necessary forms, if any. The investment firm can help you track your earnings and shift the investment type within the 401K if you decide to do so.
Benefits
The 401K is a powerful retirement savings tool. Though there are lots of restrictions on a 401K, the benefits outweigh them. You are allowed to withdraw money early from your fund, but you will have to pay early withdraw penalties to the government. However, if you want to move your 401K from the management of one fund to another, you can do so with fewer or no penalties.The nice thing about a 401K is that you get to decide how the money is invested. Many funds offer a variety of investment options that include money market accounts as well as stocks and bonds. The options given to an employee are often broken down into categories. These include investments in high, low, and medium risk funds.
Stock market is usually considered to be a high-risk investment, where returns are not guaranteed. Investments in this category may sometimes lose money, but they also offer the chance for a higher return.
Bonds are a low-risk investment option. These are guaranteed to give at least a minimal return. These investments are guaranteed not to decrease in value and therefore they are viewed as being a safe investment option.
A mutual fund is a medium-risk investment option because it is made up of a combination of high- and low-risk investments. The fund may lose value but any potential loss will be offset by the security of the low-risk investments. The fund has the potential to yield higher returns than low-risk funds but the returns are never guaranteed.