Employer-sponsored 401(k) plans offer some tax advantages but come with some caveats. Depending on whether the plan is a traditional or Roth 401(k), the tax benefits and potential penalties will differ. The plans often offer matching contributions from employers, essentially free money that lets your funds grow faster. However, some 401(k) plans have significant administrative fees that can hurt growth potential, and the selection of investments may be limited.
Traditional and Roth
There are two kinds of 401(k) plans: the traditional option and Roth plans. They offer different kinds of tax structure. In a traditional 401(k), contributions are made before taxes are taken out, so taxes are deferred on the amount you contribute and earnings. Taxes are levied on withdrawals. The Roth 401(k) offers the reverse -- taxes are taken out before contributions go into the plan, but the withdrawals of contributions and earnings are tax-free. Traditional 401(k) contributions are tax-deductible, so they allow workers to shield part of their income from taxes while the money grows.
Unlike an individual retirement account, 401(k) plans are sponsored by employers. Depending on the plan, the employer can match up to 6 percent of an employee's contributions. This is essentially free money that goes right into investments, helping your savings grow. Because 401(k) plans come through employers, it is also possible for employees to set up automatic contributions from their salary directly to the plan, making it easier to manage adding money.
The downside of employer sponsorship is that the employer controls the investment packages from which employees can choose. There might not be good options available for every employee. For example, one employer might only offer two plans, both of which offer safe, low-yield returns. These would be inappropriate for a younger worker who is more risk-tolerant and wants higher returns. However, because the 401(k) is tied to the employer, he cannot seek a better fit elsewhere.
Fees and Penalties
Some 401(k) plans will have administrative fees that take a percentage of the fund. If the fees are steep enough, they can eliminate the advantage of using a 401(k) in the first place, and the above-mentioned lack of options means that workers might be stuck with high-fee plans. The plans also have penalties for withdrawing before the age of 59 1/2 -- up to 10 percent of the amount withdrawn. This means retirement savings in 401(k) plans shouldn't be considered general liquid assets, although you can borrow from 401(k) plans in emergencies.
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