401(k) plans are retirement plans that are sanctioned by the IRS. These plans are considered tax shelters, which help you save money for your future. They have special contribution and withdrawal restrictions, however. When considering a 401(k) plan, you'll also want to know how 401(k) plans accumulate money when compared to other investments.
Both you and your employer make contributions to the 401(k) plan. Then, money is invested in mutual funds. A mutual fund is a collection of stocks or bonds with a common investment objective. The mutual fund provides diversification in your investment portfolio because it represents a wide range of individual investments embedded within one investment product.
The significance of a 401(k) is that the mutual funds inside of the account are not subject to taxation until the money is withdrawn from the account. This differs when compared to other investments that are taxed when the investment is sold or when dividends generated by the investment are paid out. Mutual funds in a 401(k) can be bought and sold without incurring any taxation.
The benefits of a 401(k) plan are that the earnings are not taxed and you can choose among a wide range of funds in the plan. This makes many 401(k) plans versatile and allows you to build up a sizable retirement savings over time. Many 401(k) plans also offer managed account options so that you don't have to choose funds. Instead, you choose between being "conservative," "moderate," or "aggressive." This makes investing for retirement easier than having to choose between individual mutual fund investments.
The disadvantage to 401(k) plans when compared to other investments is that growth in the 401(k) plan is limited to mutual funds. Other investments may earn interest and grow your retirement savings using different financial markets or different strategies. With a 401(k), you typically only have one way to make money. Additionally, withdrawals are always taxed at ordinary income tax rates instead of the often lower capital gains tax rates.
Before investing in a 401(k), consider other investments such as individual stocks, real estate investments, bonds or precious metals. Additionally, consider annuities. Annuities provide similar tax advantages as 401(k) plans, but guarantee you an income during retirement that you cannot outlive. Annuities do not accept pretax contributions, and the gains in the account are taxed at ordinary income tax rates when they are withdrawn.
- "Practicing Financial Planning for Professionals (Practitioners' Edition), 10th Edition"; Sid Mittra, Anandi P. Sahu, Robert A Crane; 2007
- IRS: 401k Plans
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