A 401(k) is a retirement savings plan sponsored by your employer, also known as a defined contribution plan. Similar plans include 403(b) plans (provided to employees of tax-exempt organizations like non-profits, schools, and religious groups) and 457(b) plans (provided to government employees).
Gaining popularity in the early 1980s, 401(k) plans are typically used by companies to replace or supplement pensions. While a 401(k) is a very common retirement savings vehicle, it’s important to realize that you, as the employee, shoulder all of the investment risk—not your employer.
How does a 401(k) work?
You elect to deduct a certain amount from every paycheck to invest into your 401(k). For every paycheck, this amount gets deposited into your 401(k) account before it gets taxed. Though your employer chooses a company to administer the plan, you choose from the investment options in the plan where to invest the funds. Most options in the plan are investments and do not provide guarantees on the value, so you are taking on the investment risk. If the options you choose do well, your value increases and you benefit. If not, your value decreases and you may lose money. Fortunately, most plans offer a variety of mutual funds to invest in, thus giving you more options.
You can withdraw your money without penalty during your retirement (starting at age 59½), at which point it will be taxed for the first time. If you want to withdraw from your 401(k) before you reach retirement age, you’ll face a 10% penalty. Many people use 401(k) plans as the cornerstone of their retirement nest egg, but it may not be wise to rely on it as your only income source.
Benefits of a 401(k)
Since your principle is only taxed when you withdraw it in retirement, you may pay fewer taxes on this principle because your tax rate may be lower in retirement. In addition, many employers will match a portion of your 401(k) contribution up to a certain point, rewarding you with extra, deferred-tax retirement savings.
Risks of 401(k)
Though 401(k) plans are the backbone of many sustainable retirement plans, they do come with certain restrictions and risks. First, they aren’t very liquid, meaning the plan typically doesn’t allow you to withdraw or use the money whenever you want. And then there’s the 10% penalty for early withdrawal prior to age 59 ½. In addition, if you take an early withdrawal, you will need to pay taxes on those funds during the tax year in which you withdrew them. Together, the penalty and taxes can be a steep price, depending on amount you withdraw.
Most importantly, the 401(k) value is not guaranteed. Because 401(k)s are based on investments, their value rises and falls with the markets. If you’re nearing retirement, that can make planning for retirement more challenging due to the investment risk.
While your 401(k) is tied to your employer, changing jobs doesn’t have to derail your plans for retirement. Most 401(k)s can be transferred your new employers plan or the funds can be transferred into an IRA.