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401K

definition and explanation

Synonyms:

retirement plan, 401k plan

What is

401K

A 401(k) is a retirement savings plan that allows employees to contribute a portion of their paycheck to a tax-deferred account. Employers may also match a portion of employee contributions.

401K

explained

A 401(k) is a retirement savings plan sponsored by an employer. It lets workers save and invest a portion of their paycheck before taxes are taken out. When employees leave their job, they can take their 401(k) with them.

401(k)s are one of the most popular retirement savings vehicles in the United States. As of 2019, there were over 700,000 401(k) plans with over $5.6 trillion in assets.

There are many benefits to having a 401(k). First, the money that workers contribute to their 401(k) is deducted from their taxable income. This reduces their tax liability and could put them in a lower tax bracket.

Second, the earnings on 401(k) investments grow tax-deferred. This means that workers don’t have to pay taxes on the interest, dividends, or capital gains they earn on their investments.

Third, 401(k)s offer employer matching contributions in some cases. This is free money that employers contribute to their workers’ 401(k)s, which can help employees save for retirement even faster.

Fourth, 401(k)s are portable. This means that employees can take their 401(k) with them if they leave their job. They can either roll it over into a new employer’s 401(k) plan or into an Individual Retirement Account (IRA).

Finally, 401(k)s have tax-advantaged withdrawal options. Workers can start taking distributions from their 401(k) at age 59½ without having to pay a 10% early withdrawal penalty. They will still have to pay taxes on their distributions, but they can spread the taxes out over their lifetime by taking required minimum distributions (RMDs) starting at age 72.

For all these reasons, 401(k)s can be a great way for workers to save for retirement.

However, there are some drawbacks to 401(k)s that workers should be aware of.

First, 401(k)s have high fees. The average 401(k) plan has fees of 1.3% per year, which can eat into workers’ investment returns.

Second, 401(k)s are subject to investment risk. This means that the value of workers’ 401(k)s can go up or down, and there’s no guarantee that they will have enough money saved when they retire.

Third, 401(k)s have contribution limits. In 2020, workers can contribute up to $19,500 to their 401(k)s. This may not be enough to save for a comfortable retirement.

Fourth, 401(k)s don’t offer guaranteed income in retirement. This means that workers could outlive their 401(k) savings.

Finally, 401(k)s are not accessible in financial emergencies. Workers who need to tap into their 401(k)s before retirement will have to pay a 10% early withdrawal penalty, as well as taxes on their distributions.

Despite these drawbacks, 401(k)s can still be a valuable retirement savings tool for workers. Employers who offer 401(k)s to their employees can help them save for retirement and enjoy the many benefits of a 401(k).

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