A 401(k) plan is an employer-offered and managed investment fund that you contribute to on a tax-deferred basis through your payroll plan. The plan is defined as “tax-deferred” because your contributions are deducted from your wages before your payroll taxes. Your contributions are deposited into a tax-free savings account (usually of a type called a “money market account”). You pay taxes only on the money you withdraw from your 401(k) account an d only at the time you withdraw the money.
To discourage people from withdrawing their money too soon, Federal rules require that a 10% penalty be paid on any withdrawals before you reach retirement age (and a few other exceptions may be allowed).
If you invest enough money in a 401(k) plan (usually about $10,000) you are permitted to keep it when you leave the employer who set it up for. If you don’t have enough money in the plan, you’ll have to either make a penalty withdrawal to “cash out” or you’ll have to roll the plan into an IRA (Independent Retirement Account) or another employer’s 401(k) plan.
About half of all 401(k) plans are cashed out, and the percentage increases during bad economic times. Although the 401(k) concept was originally popular and available only to the wealthiest of business people, in the 1980s the Reagan administration oversaw the expansion of workplace benefits programs to increase investment. 401(k) plans are not as easy to maintain for people of average income as for high income people and the news media have covered many 401(k) disasters during every recession since the 1980s.
The law limits how much money you may contribute to a 401(k) plan to 15-20% of your salary depending on your age. Most people contribute only 2-4% of their salaries, thus building wealth at a very slow pace. Unfortunately, it is inadvisable to contribute more money than you can live without as a 401(k) plan is a long-term investment option. It should not be regarded as a safe harbor for money you anticipate needing in the next 5-10 years.
Most if not all 401(k) plans allow you to borrow money against the value of your investments. These loans are provided at reasonable, often competitive interest rates compared to those you would be charged by a bank or lending institution. You are required by law to repay the loans wihin 5 years and may be charged taxes and a penalty if you fail to do so. 401(k) loans do not affect your credit worthiness.
A typical 401(k) plan allows you to move your money between investment accounts. Your employer decides how many different types of accounts and how many accounts your plan includes. A good mix covers the four major types of investment accounts (large income, small income, long-term wealth investment, and bonds). Financial advisers generally recommend that you spread your investment across several different types of accounts, diversifying your risks as the markets may fluctuate at different rates and times for each type of investment.
If you know you will be borrowing money from your 401(k) plan it is a good idea to maintain enough value in your plan’s money market account to cover the anticipated loan. This way your plan administrator will not be forced to cash you out of your other investments before they have had time to grow.
The investment accounts offered by 401(k) plans are almost always mutual stock funds, managed by professional fund managers, which invest in several different companies according to precise criteria. Your 401(k) may offer you several funds in each category. As each investment fund manager follows his own strategies, comparable funds may perform differently during each year. Some investment fund managers anticipate declines in stock value and invest for negative growth. Some investment fund managers anticipate rapid growth in certain stocks and invest in high-risk strategies.
You are ultimately responsible for managing the risks you take with your 401(k) investments. Although some financial advisers may assist clients with their 401(k) investments, there is no insurance to protect you against unwise investments.
It is best to only contribute as much money as you can afford to live without. Some people dedicate all or most of their raises to their 401(k) contributions because they are already living on carefully defined budget plans. Your budget should, however, include money that you invest outside of your 401(k) plan (such as in a savings account or money market account) so that you have good liquidity (the ability to “cash out” quickly) that is not subject to penalties or interest.