A 401(k) plan is a long-term investment plan that many companies offer as a perk to employees. While the plans have positive and negative aspects, any type of vehicle that encourages long-term savings is a good thing, especially when there may be tax advantages involved. A 401(k) can be complicated to operate from an employer's perspective, but as an employee, you can invest in this type of retirement plan with relative ease.
One of the main benefits of a 401(k) plan is that your money grows tax-deferred while in the account. Unlike in regular taxable investment accounts, you do not have to pay any tax on your interest, dividends or capital gains while the money remains in your account. Once you withdraw your funds, all of that money is taxable as ordinary income, even if it is comprised solely of capital gains. As capital gains are typically taxed at a lower rate than ordinary income, this is a negative of a 401(k) plan.
For an employee, a 401(k) provides an easy introduction to the world of investments. Typically, such a plan offers a choice of mutual funds in which to invest, ranging from conservative bond funds to aggressive small-company and emerging-market stock funds. Each fund is professionally managed and diversified, generally reducing the overall investment risk. However, while 401(k) plans tend to make investing more easy, they also limited in investment choices. In a regular investment account, you could choose from any stock, bond or mutual fund in the world that you want to invest in. Your 401(k) may limit your choices to a handful of offerings.
Company matching is one of the best perks of a 401(k) plan. Under a matching plan, your employer will contribute money to your account based on a formula. This match can range anywhere from zero to 100 percent of the amount you contributed yourself, although the match is usually limited to a certain maximum. The only real downside of matching is that the trend has been toward a reduction in the amount that companies match in employee 401(k) accounts.
One of the other negatives of a 401(k) plan is that your access to your money is severely restricted. In most cases, you can withdraw from your 401(k) only in the event of demonstrable financial difficulty -- in which case you also incur a 10 percent penalty -- or if you are over age 59 1/2. However, this also makes it more difficult for you to spend down your long-term retirement savings for a short-term want or need.
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