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What is a 401(k)?
Every month a predetermined amount is taken from your salary and put into a separate account with multiple investment options. The money is taken out “pre-tax” meaning that the normal portion of your income going to taxes is not taken out of a 401(k) contribution. The average amount of annual employee contribution is $6,940, and the compound annual average growth rate of 401(k) plans is 14.2%. On average, employees are offered 10 different plans they can choose from, with varying contributions.
While 401(k) is the most popular version of the defined-contribution plans, it is important to differentiate between similar employer-sponsored plans that are offered for different criteria. In particular, the 401(k) plan is the version that corporations offer to their employees. 403(b) plans are for employees of the public education entities and most nonprofit organizations. 457 plans are for state and municipal employees, as well as employees of qualified nonprofits. Thift Savings Plans (TSPs) are for federal employees.
Besides the traditional 401(k) plan there is also a Roth 401(k) savings plan, the main difference between the two being the way they are taxed. In a 401(k) plan, contributions to the account are not taxed, but when the employee reaches retirement age and they withdraw their savings, they will be taxed. With a Roth 401(k) employees are taxed ahead, but their withdrawals are tax-free.
Why should employers choose 401(k) vendors?
Time is of the essence when it comes to retirement plans.
Employers can choose to simplify this process by administering their 401(k) plans through a vendor. Retirement plan professionals will design a plan that matches the organization’s size and needs of the employer. Some of the benefits of using a vendor is that they handle all the paperwork and maintenance regarding the financial, tax, and legal aspects of the 401(k) plans, which saves the employer a lot of time and trouble. Through integration and automation, the payroll process can also be simplified by having the payments and contributions automatically deducted.
There are certain things the employer should be mindful of when choosing a vendor. In particular, the fees and compensation for the services they provide, the flexibility of the vendor, if they offer loans and hardship withdrawals as an option for the employees, if they offer both traditional and Roth plans, to name a few. By choosing a vendor, the company is ensuring the investments of the employees are smart and compliant with all current laws, reporting requirements, and standards. It also gives access to professional consultations to employees regarding their investments.
Understanding how your 401(k)-savings plan works is the first step to ensuring you have a comfortable life in your golden years.
Choosing between a 401(k), IRA, or a Roth 401(k) might be overwhelming for any employee, especially young professionals who are just starting out their careers. Employees should get a consultation from the vendor’s financial experts before they commit to a plan that works best with their individual needs and investing goals.
What the 401(k) does for you
The 401(k) plan gives a sense of stability and security to employees, thus being the most popular plan for saving money for retirement, with the second option being saving in a savings account.
Considering more than half of the current workforce in the U.S. has access to 401(k) plans, the participation rate is relatively low with only a third of all employees contributing to one. Despite low salaries and high debt loads, Millennials have a surprisingly high participation rate (82%) in 401(k) plans, surpassing the participation rate of both Baby Boomers (75%) and Generation X (77%).
The most common reason employees are put off from contributing is simply because they do not understand how these plans work. A lot of unfamiliar terminology can be intimidating for anyone, especially when it involves someone taking a chunk of your salary every month, hence why every employee needs to understand how these defined-contribution plans work.
Advantages of a 401(k)
Although every employer’s plan has different rules on loans and hardship withdrawals, many allow taking loans, meaning that you can borrow money from your own savings account and repay yourself within 5 years. The interest paid is usually lower than any interest rate at a bank or a consumer loan, and it goes back to your retirement savings account.
If you are eligible to participate, the 401(k) plan allows for bigger contributions than an Individual Retirement Account (IRA). For 2020, the limit for retirement contribution is set at $19,500. Employees over 50 years are allowed to catch up and save an additional $6,500 above the limit. The maximum joint annual contribution by both employer and employee is $57,000, or for those aged 50 and older it is set at $63,500. Individual Retirement Accounts (IRA) are limited at $6,000.
Most 401(k) plans offer a variety of investment options to choose from, with varying levels of risk and reward potential. The most popular plans are bond mutual funds, stock mutual funds, money market funds, and some employers even give the option to invest in the company’s own stock. More than half of 401(k) plan assets were held in mutual funds, the remaining assets include company stock, individual stocks and bonds, guaranteed investment contracts (GICs) and other investments.
COVID-19 AND WITHDRAWALS
This year with millions becoming unemployed and the economy taking a hit due to COVID-19, the government signed a relief bill in order to stimulate the economy. The new bill allows people under 59.5 years to withdraw up to $100,000 from their 401k savings plan without the 10% penalty fee and an extended window of 3 years to pay the income tax.
Your 401(k) plan is portable, meaning that even if you switch jobs or change the company you work for you can roll over your 401(k) into an IRA, a Roth IRA, or switch to a new employer’s 401(k) plan. However, keep in mind that if you have a loan and end up without your current job you will be required to pay back the loan in a very short amount of time.
Another advantage is employers making a matching contribution, usually 50 cents on every dollar of the employee’s contribution. Invest in your 401(k) plan up to your company match. Employer-contributions are only available for the traditional 401(k) model and not for Roth 401(k).
Starting early will ensure you have built up a sizeable nest by the time you reach retirement age. It is important to remember that these investments have a compounding interest, meaning the more you put in, the longer you do it, the higher the profit.
One of the discernable advantages of the 401k plan is that employees get an immediate tax break because contributions are withdrawn from their salary before it is taxed. You get to reduce your earned income by the contribution amount, so at the end of the year you will be taxed on a smaller amount.
Disadvantages of a 401(k)
Most plans are only to be accessed when you are older than 59.5 years, any early withdrawal is difficult to get approved. It will also be taxed like normal income and bear a 10% penalty. For example, on a $10,000 early withdrawal after all the penalties and taxes, you will end up with approximately $6,300.
There are exceptions for when early withdrawals are permissible, also known as hardship withdrawals. The conditions are withdrawal to avoid eviction or foreclosure, money for sudden disability, burial expenses, medical expenses, etc.
One of the biggest disadvantages is that oftent through whatever circumstances in life, many employees are forced to dip into their retirement savings and make an early withdrawal. In fact, one in three workers have made an early withdrawal.
Although most plans now offer personalized communication to participants, such as webinars and through mobile apps, the employers also have to take initiative to educate new hires and ensure their employees understand these plans.
Hidden Fees and Costs
Another disadvantage is the high administrative and investment costs which may be hidden. Generally, you can expect four different types of costs and fees.
After all the costs and fees involved are added up, the cost of administering a 401(k) might be quite high.
Keep in mind that it is usually the employer that decides who covers these expenses, and more often than not it is the employee that has to cover them. It is always advisable to be informed about the actual cost of maintaining a 401(k) account and choose a plan with low management fees.
Choosing between a 401(k), IRA, or a Roth 401(k) might be overwhelming for any employee, especially young professionals who are just starting out their careers. However, putting it off will stop you from maximizing your financial growth. Understanding how your 401(k)-savings plan works is the first and most crucial step of ensuring you have a comfortable life in your golden years.