A 401k retirement plan has been around since 1978. It has grown to be the most popular retirement plans.
If you look at statistics, one thing is clearly evident, millions of people have benefitted from this plan. Still, employers have used this plan to their advantage, distributing their stock to the employees through the aid of this plan.
With the rising cost of living, there is a pressure to save more for retirement. This is reflected in the average value of retirement accounts by family. As you can see in the following chart using FED Survey of Consumer Finances data, in 2001, the average was $151,000, but this has increased steadily over time to an average of $255,000 in 2019. However, the median figures have not seen such a dramatic increase, growing from $42,000 to $65,000 in the same period.
Is the plan available for the self-employed?
Well, it is a question that on the surface could be so confusing but yes, it does. What normally happens, the plan allows you to endow a part of your paycheck before cutting the tax.
A recent development in the 401k retirement plan is the emergence of some variations – these are the simple 401k and the safe harbor 401(k). One more important thing is that the money from your paycheck is deducted on a pre-tax basis.
This reduces your annual taxable income and the amount of tax you have to pay. In reality, you will not be paying your income tax on contributions until you decide to take withdrawals or even borrow in the future.
The Roth 401k is another option that’s becoming more and more popular With this plan, you’ll get to pay tax upfront. Typically, you don’t even have to pay any tax on future withdrawals of contributions or on the investment earnings.
Nonetheless, with the advantages that we get from the 401k plan, many people are still dormant when it comes to using the plan because they have little knowledge about these plans. But first, let us analyze what these plans are.
What Is 401(k) Plan?
Basically, this is an arrangement that allows the employee to choose whether to take cash compensations or to defer them to a 401(k) account. The amount that the employee defers is usually not taxable not unless it is withdrawn.
Usually, upon withdrawal, that is when taxation begins or when the amount is distributed.
Usually, if the plan permits, the after-tax basis can be applied to make contributions, which are better known as Roth 401(k) plans. One advantage of the Roth account is that even upon withdrawal, they are tax-free.
This is an improved system of saving. Earlier, it was common to find employers creating and offering pension plans to support workers but nowadays, what is more, common are the 401(k) plans.
To sum up:
It gives employees charge over their own retirement plan and account. What makes the 401(k) plans special is that an employee determines how much there will be in his account, upon retirement.
Advantages Of 401(k) Plan
What you have to understand about the 401(k) plan is that it is a feature of a qualified profit-sharing plan. This allows most of the employees to make rational contributions to their retirement account.
The plan comes with a lot of benefits including some of the following.
This makes the plan one of the best. In its basket of opportunity, what you get as the first option is the contribution flexibility. 90% prefer this coming from the employee voluntary measures. An employee could be deferring up to $16,500 a year.
For the older employees who constitute about 65% or who are about 50+ years old can contribute up to an extra of $5,500 a year.
What makes this a lot better?
The fact that employers can draft a vesting schedule for the contribution the company will have to make to the plan. This has to be within certain guidelines for the plan to work. Even so, the employers don't have to make any contribution to the plan.
However, the only time that the employer may have to make some obligations to contribute is when the plan is considered a top heavy after annual nondiscrimination testing.
Federal Legal Protection
What most people don’t know is that workplace retirement plans are protected by federal law. This federal law is called the Employee Retirement Income Security Act of 1974. What the law does is that it sets a minimum standard for the employers who choose to set the retirement plans.
90% of the employers have set retirement plans for their employees.
3 out 5 people get advantage from the legal law. This law ensures the protection of the employee interests and those of their beneficiaries. Participation in a retirement plan at work will result in the following;
- 80% of the people participating in the retirement plan get protection on the disclosure of important documents. Also, facts about your plan’s features and funding remain at your disposal.
- You have a legal right to claims and appeals process to make sure that your benefit from the plan. 8 out of 10 people who have are not under the retirement plan will get an appeal for their benefits.
- As a person, you have the legal right to sue for the benefits and breaches of fiduciary duty if the plan is somehow mismanaged.
- If the retirement plan at your work place is terminated, you have the right to claim for certain benefits if you lose your job.
These are just some of the benefits that you get from the legal protection under the ERISA Act. However, I have to bring this to your attention. Something that most people don’t know is that the Act can also protect you from the creditors.
Let’s look at it in detail:
Let’s say you have a loan that you owe to a certain person. Unfortunately, you lose your job and you are not able to pay up your loan. The person will end up suing you.
However, if you have money in your ERISA qualified account, the lenders cannot be able to collect the money from your 401k plan.
The plan offers a lot of tax benefits to the user. You can contribute a portion income to the plan on the pre-tax basis. Therefore, the overall benefit of this is that it will lower your taxable income. In addition to that, your 401(k) earnings will usually accrue on a tax-deferred basis.
What does this mean?
Well, your dividends and the capital gains earned are not subjective to taxes until you decide to withdraw them.
The Matching Contribution
90% of most employers offer a matching contribution to the 401(K) plan. Which they may also offer a profit sharing feature on the plan. Most of the companies out there offer a 50% of the first 6% you contribute to the plan.
Take a look:
Let's say you earn a salary of about $50, 000 and contribute the 6% of your salary to the plan, your employer will be forced to contribute 50% to the plan. You will be contributing 6% = $3,000. The employer would be contributing 50% = $1,500. More to that, some employers offer what is called a dollar-for-dollar match for the first 6%.
In this example, the employer would have to match the $3000.
High Contribution Limit
As of 2019, the annual allowable 401k contribution limit has been increased to about $ 19,000. If you are 50+ years of age, the limit has been extended to about $ 25,000. This could be intimidating if you are just starting out.
What's the preferred contribution ratio?
To beat this, as your primary goal, you should aim to set aside not less than 10% to 15% of your gross income for your retirement. For the people who earn higher incomes, make sure that your plan will stop taking the contribution once you reach the optimal annual limit. By making flat equal payments, you could be preventing making more contributions.
What happens if you can’t get near the maximum?
If this happens, contribute a percentage instead. It is the next best alternative. Most of the plans there are in the 401k category automatically increase your contribution percentage every new year. Therefore, you do not have to worry about being stuck in one place, every year.
Protection From Creditors
The 401k plans offer excellent protection from creditors. Basically, they are ERISA qualified retirement plans and therefore this offers you guaranteed protection. More to that, these loans offer some protection from the federal tax liens.
Your 401k plan legally belong to the employer, it makes it more difficult for the IRS to place a lien on your account. However, it is important to mention that depending on the fine print of your account, the plan administrator may be able to refute compliance with the IRS lien.
Disadvantages Of 401k
Over the past quarter, we’ve major hallmarks and evolution of the 401k plans making them very popular amongst most of the US workers. However, there are still additional problems that still arise from the plans that need assessment. The following are the disadvantages that arise from the plan.
This is one of the major disadvantages of the 401k plans. You will be forced to withdrawal all your money when you reach a certain age bracket and there after that, you cannot be able to contribute. When you reach the age of 70 and a half, you cannot be able to make contributions to the plan. Whilst this may seem like the ideal age, the average retirement age is increasing as the days go by.
Your Money Will Still Be Taxed
This is another major downfall of the 401k plans. You may get an annual tax break for your contribution to the 401k plan. However, what most people haven’t realized is that it all comes back to you when you withdraw your money.
The main drawback in this is that the tax is cut as a whole and this could “eat” away from a large portion of your money.
Long Waiting Periods
Generally, the waiting periods at an employer are long before you can actually begin to contribute to the 401k plan. The waiting period could go up to one year.
Although this has not been really a problem, it could really inconvenience the people who want to start saving early.
Yet another huge disadvantage of the plan. Some of the employers may not allow you to contribute as much as you would like to contribute to the plan. Still, they may also choose to match your contributions. This becomes a huge restriction because in either case, you will not be able to make the contributions that you would prefer.
The Plan Is Market Driven
What most people have not realized is that when you place your money in a 401k plan, you’ll not enjoy the insurance benefits. As a matter of fact, depending on the investment that you’ve made, you could end up losing all your money when tied up in a 401k plan.
Therefore it is wiser that if you start noticing change or loss on your investment, consider changing your plan option.
Things to Consider about 401k Plan
Here are some things to consider when choosing 401k plan:
- Understand what your strategy entails and how to make the most of it – Only through educating yourself will you be able to do this. Take advantage of any educational possibilities provided by your employer. Read all of the plan materials provided by your company – Find a handful of solid 401k websites, such as 401khelpcenter.com, by searching the internet. Recognize your investment choices. Pose inquiries.
- Even if you think you can't afford it, don't put off contributing to your 401k – Time is your best assurance of meeting your retirement objectives, so the sooner you start saving, the better off you'll be in retirement. Even a 1% increase will make a significant difference.
- A Summary Plan Description must be provided to you by the plan sponsor – Take a look at it! It offers a wealth of useful information about how your plan operates, what options are available, who the trustees are, and other crucial details. If you misplace your copy, you can always request another.
- A 401k is not a savings account – it is a retirement plan. In the event of an emergency, money saved in a 401k is difficult to obtain. Loans and hardship withdrawals are permitted in some plans, but the restrictions governing them are rigorous.
Saving for retirement is one of the best things that you could do. However, at your disposal, there are many investment options that you could choose to work with. One of them being the 401k plans.
These plans are generally offered by an employer but that doesn’t mean that you cannot utilize them if you are self-employed. Therefore, take advantage of this plan and save for your retirement before time elapses.