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Understanding the Pros and Cons of 401(k) Retirement Planning

Jun 8, 2008
One of the most popular retirement plans operational in the USA and other developed countries which work on similar financial basis, 401(k) Retirement Plan is the first thing that comes to mind when an individual is planning to retire from active working life. First introduced in 1978 by IRC, or the Internal Revenue Code, the primary focus of the 401(k) Retirement Plan is to offer tax benefits to the individual on the sum of money which he is not withdrawing from his salary, but putting it aside for using after retirement. Currently this plan is implemented by the Employee Benefits Security Administration or ESBA under the Department of Labor.

The central corpus fund in the 401(k) Retirement Plan is generated by contributions made by employees through out the country as well as an equal contribution made by the respective employers. One could call this plan an employer-sponsored contribution plan. The biggest advantage of this plan, from the employee perspective is that his contribution towards the plan is completely free of tax, till such times that he withdraws his contribution from the corpus.

Hence, the 401(k) Retirement Plan defers tax until withdrawn. The allowable age for withdrawal is 59.5 years, but it can be withdrawn before that in case of hardships. These hardships include events like paying for mortgages, payments to avoid foreclosures, funeral expenses, educational expenses, home improvements and such other things. If the amount is withdrawn for such hardships, there is a 10% deduction from the distributed amount.

Investing in 401(k) Retirement Plan makes good sense as you can expect a huge sum of money as and when you retire. If you invest in this plan for 20 to 30 years the compounding benefit of 401(k) Retirement Plan is truly great. This is because the employer is also simultaneously contributing to your savings, which doubles your investment. If you change jobs, you could transfer your accumulated funds of the 401(k) Retirement Plan to your subsequent employers. The flexibility of the 401(k) Retirement Plan allows you to do so conveniently.

One of the main advantages of the plan that makes it popular is the tax-free nature of the contributions before they are withdrawn. And since the contributed income is not taxed, the member is able to get bigger savings compared to other investment plans. This is perhaps the only financial planning strategy which is not deducted with taxes.

However, withdrawing the plan before the contributor reaches 59.5 years of age is unwise considering the 10% penalty imposed on such withdrawals. There are other disadvantages to the plan such that it is not insured by the Pension Benefit Guaranty Corp. The employee also needs to render several years of service before the plan is approved by the employer. Until then, it is only the employee who will contribute to the plan. The employer's contribution will only be credited once the required tenure is served.

The 401(k) plan increases your scope for investments, though. You can invest in mutual funds such as treasuries, stock funds, money market funds and bond funds. You may also invest in the stock of the company itself and in the American Savings Bonds. You have the liberty to choose which manner you want your savings to be made in.

An employee, who is quite sure of staying for a longer period in the company where he is presently working, should consider the advantages of the 401(k) plan. It is a good investment option but try to weigh the advantages and disadvantages before you decide if the 401(k) is the right investment vehicle for you. There are lots of investment options available for retirement purposes but so far it is the 401(k) retirement plan that attracts employees because they are not the only one contributing to their retirement fund since the employer also contributes to the fund making. Consider these options and decide which will benefit you in the future.
About the Author
The author is a participating researcher for Retirement Planning Software and specializes on topics involving 401k retirement planning.
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