Benefits and Risk of Plan 401(k)

by Manshu on November 16, 2006

in Articles

401(K) plan is one of the most critical financial instrument for any individual in US. Hence, its very important to know about the benefits and risks involved in the plan.

This plan was initially meant for the executives but it was the workers who popularised it as they found the yearly contribution limits to be higher than the limits provided to them in the Individual Retirement Account (IRA). Moreover Plan 401(k) also included a matching contribution from the employer. There is more flexibility in this plan than in the Individual Retirement Arrangement (IRA). One can also avail of loans and if required, offer the employer’s stock as an investment alternative.

The 401(k) Plan, unlike other retirement plans, allows the employees to operate their own accounts. It allows them to select the areas of investment and make suitable investments which they feel will provide them with better returns. They have a choice and can seek or reject proposals on their own terms and the investments can be made in professionally managed funds with no minimum requirements however sometimes you find that some of the retail financial service providers do have minimum investment requirements. If you have a Plan 401(k) account you can start by investing small amounts at a time. As your contributions are deducted directly from the salary the loss from the pay packet is hardly missed as you never get to see the money at the time anyway.

The contributions into this account are made from your salary amounts available before tax can be deducted. This means you save on tax until you withdraw money from your account and withdrawals are generally made after retirement. Even here there is a tax saving because the tax bracket after retirement is much lower. Therefore, the amount deducted on your withdrawals will be lesser than it would be during your working period. The result, you have more money working for you under Plan 401(k) and the growth would be that much faster.

The employer’s contribution too helps as you will have a larger fund working for you. To give an example, suppose your employer contributes 50% of your contribution then for every $ 100 that you contribute; your employer will add another $50. You get instant benefit from this facility under this plan.

You might be tempted to use funds from the employer’s contribution under Plan 401(k) to pay the down payment on your dream house. Though sometimes you are allowed to withdraw from the Plan because of hardship, you will have to pay taxes and penalties on the amount withdrawn and that too must be paid in the same year. Even if you borrow the money from the plan account you have to pay the interest which goes back into your account. The risk here is that in case you leave your job or might just lose it then you have to pay the loan in full, that too within a short period of time. In case you do not pay or are not able to in that short period then this loan is considered as withdrawal and you have to pay tax as well as penalties. At the same time you lose compound interest and overall your account becomes much smaller. Hardship withdrawal is always risky and best avoided.

The actual benefits and risk vary from person to person. However, a honest introspection of your financial position, will make the plan most beneficiary to you.

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