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3 401K Retirement Plan: Understanding the ABCs Have you heard about 401K retirement plans? Are you working in a company that offers such kind of saving plan? Or have you been encouraged by your coemployees to join in your company s 401K retirement plan? Well, the 401K plan is not actually a new concept. It has been in existence for more than a decade now and many have already considered it as one of the most effective ways of investing and saving money for retirement. It is nice to know that the 401K plan was first designed and considered to determine those who are familiar with the time value of money. The time value of money is actually a concept that involves the proper handling of money in a way to save bucks for the future. It is simply like having a $1 in your hand now and having $1 tomorrow, in which case the $1 you have in hand right now matters more than the $1 that you may get a year from now. Get the idea? Well, that s basically is the principle of the time value of money, and the 401K retirement plan is to some degree designed with such principle in mind. So the 401K retirement plan is basically designed for those who have realized that every dollar you may get, regardless of how big or small it is, matters most and may help support you in the future if you consider compounding them over long periods of time. As expected, they can result in thousands or even millions or billions of dollars. That means additional wealth to your part. It is for such fact actually that many of the companies these days have considered tax-advanced accounts and investments that their employees may wish to participate. The usual target of these accounts and investments are actually those who are thinking of retiring from work knowing the fact that every man and

4 woman who wishes to leave the work force someday needs to have an income that can suitably support their living after the retirement. Fortunately, in today s highly competitive and demanding world, saving plans like the 401K were introduced and highly valued. But what really is 401K retirement plan? What is involved in the plan? How does it work? Are there any limits attached to it? What are its advantages and disadvantages? Well, let s take it slowly. After all, that s the best way to learn. So if you are wondering everything about 401K retirement plans, then you must read on. I have actually mentioned below some of the most worth-noting facts about 401K. These are just the basics, as what the title suggests, but I bet this is enough for you to understand and get started with your retirement plan. What is 401K Retirement Plan? Established by the US tax code, the 401K retirement plan is in the first place a retirement savings plan that is funded by the contributions of the employee and the matching contributions of the employer in a particular company. The main highlight of this plan is actually the contributions that are taken from the pre-tax salary of the employers and the employees. The contribution then became a fund which grows tax-free until withdrawn by those who may be thinking about retirement. The 401K retirement plan takes its name from one of the sections of the Internal Revenue Code of Now, can you guess the section? It s simply none other than section 401(k) which covers the availability of an optional cash or deferred method of obtaining contributions from the employees. The 401K plan is a plan qualified under the Section 401(a), which defines qualified plan trusts in general,

5 including the number of rules required for qualifications. In this sense, it is maintained that every 401K plan is already a 401a plan. How Does the 401K Plan Work? The 401K retirement plan works in a pretty simple manner. If you find that your company offers it, what is left to you actually is the decision to select from the available funds that you want to invest. The funds are often included in the 401K plan, so all you need to do is to figure out which of the funds you want most. This is also in line with deciding how much you want to invest in the fund. The percentage is considered basically. And, once you invest from the fund given to you, your contribution will automatically be deducted from your pay check prior to the taxes. According to the rules that govern the 401K retirement plan, any employee can contribute up to a percentage of their pay into the plan. There are some instances also when employers will match a percentage of your contributions, and once determined the contributions you ve placed along with any of the match contributions from the employers are then invested into the funds of your choice. What is now nice to know about the 401K is that once your contributions and the match contributions of your employees are invested into the fund, the fund will tend to grow without being taxed. Aside from that, the funds can be withdrawn when you reach the age of 59 and ½. However, it is important to note that at this time, you are entitled by the law to pay the income tax on the withdrawn funds. Is the age allowed for the withdrawal of the funds matters most to the 401K? Well, as far as I know, there are some possible ways of withdrawals of the funds from the 401K before reaching the age of 59 ½. The downside of these ways, however, is that they typically require certain kinds of penalty along with the payment of taxes.

6 The 401K plan also works in two different ways, either by a defined benefit or a defined contribution. With the former technique, the employer is entitled to promise to pay a defined amount to those who are thinking about retiring. However, there is a limit to this promise. The employers are only entitled to pay a defined amount to the retirees who have met certain criteria of eligibility. Those who have no proof of eligibility can t benefit from it. To put it simply, the defined benefit is a plan that associates the benefit to the amount of service spent by the employee. It is also based on the final average salary, and it is due to this rule that employees have the capability to predict the monthly retirement income that they might receive with this kind of 401K plan. They might also be given the chance to consider and use a lump sum benefit in case they decided to leave from the work force. On the other hand, with the defined contribution plan, the 401K defines the contributions that an employer can make. This does not include the benefit that the employee will reap at the period of his or her retirement. It is somehow clear that the defined contribution plan covered by the 401K is not a defined benefit, leaving the employee incapable of predicting a monthly retirement income. So it follows that when the employee decided to leave the company, he or she will receive the proceeds in a current or deferred annuity. Well, note that there is one possible consequence that may occur along with your plan. That s basically the time when your company gets bankrupt. If this will happen, chances are you won t get the money you ve invested into your company s fund. The reason? Once your company gets bankrupt, you may likely lose the fund. In line with the issue on bankruptcy, there are some instances when your 401K balance may decline. The question now is what you can do to solve this problem?

7 A decline in 401K balance is not a new thing. It typically happens in this kind of saving plan. But there s something you can do to repair your balance, that is, to look closely at how you are investing. Yes, what matters most is your way of investing. So if you find yourself investing too much that you ve surpassed the level of amount that your employer is putting to the fund, it s now time to reduce your investment. Lessen and diversify it. This also means adjusting your contributions so to make the most of the limits of the new contributions set. However, it is worth noting that your age and the plan policy that your company has maintained can be two of the deciding factors in your strategy in repairing your declining 401K balance. It follows then that as you age, the length of time to rebuild your retirement plan can be shorter than those who are younger than you. Reasons to Apply for 401K Retirement Plan So the basics of the 401K retirement plan are given. Now let s consider the reasons that more and more people are considering it. Later in this page, we will consider the advantages and disadvantages of the plan. But now, let s focus much on the reasons. Here are the following: Reason #1: Saving and Investing in the 401K Plan is So Easy As you may have been told, once you have placed your contributions to the 401K plan that your company offered to you, the tendency is your contributions will automatically be deducted from your paycheck. This for sure allows you to save regularly and not miss the money. Aside from that, in 401K retirement plan, your money is invested in funds of your choice. This is but part of the rule. In this case, the options for investment are typically pre-screened and this is what guarantees you to obtain an investment that has a reduced level of possible risks. This is of course is a good news.

8 Reason #2: Contributions in 401K are Made Prior to the Reduction of Taxes In the 401K retirement plan, you are not left with the responsibility to pay the taxes on your contributions until you decided to withdraw the money. In this case, you definitely have the chance to invest more. You can even consider yourself in the lower tax bracket if you wish. Now, isn t it a good idea? Reason #3: The Earnings Are Not Taxed Without Ado The explanation for this third reason of opening a 401K retirement plan is somehow similar to that mentioned in the second reason you have no responsibility for the income tax on your investment earning until the money is withdrawn. So if that is the case, you are left with the chance to set yourself in a lower tax bracket especially when you are qualified to take the money from your plan. This simply means more savings on taxes. Reason #4: You have the Right to Choose How Much You Can Contribute In the 401K retirement plan, every participant is entitled with a right to decide on the amount they want to contribute in the fund. So this means that you can choose how much you want to place or add in the fund. This of course must be in line with how much you can afford to your 401K plan. But, still there is a limit to the amount. The rule of the thumb is place an amount up to the maximum allowed by the government. Note that the maximum amount allowed by the

9 government is scheduled to increase year after year. So watch out for the changes in the contribution limit. Reason #5: You Can Own Both Your Account and Your Employer s Match Contributions Well, this is the fifth and the last common reason for opening the 401K retirement plan. This reason is simply patterned from the fact that every participant of the 401K retirement plan has the chance to own his or her accounts along with the match contributions placed by the employer. The good news is that most of the employers atch about 50 percent of an employee s contribution to the plan. This matching, nevertheless, may include a certain limit on the percentage that the employee will match. For example, you might be able to add about 10 percent of your earnings to your 401K plan. From that percentage, you employer may match the entire 10 percent or a lesser percentage to your fund. That fund will grow and you are entitled to withdraw the total fund, including the match contributions of your employer. In addition, if the idea of changing jobs occurs to you, the money you placed in your 401K retirement plan can be rolled over to your new employer or through an IRA, which is but another retirement program. So if you think that changing jobs may ruin your established 401K plan, it s now time for you to change such perception. There is always a chance for you to make your future well-planned and 401K plan is one good option. A Few Disadvantages of the 401K Plan Everything about the nature and advantages of the 401K retirement plan has been said. It s now time for you to consider certain disadvantages known to this retirement plan.

10 First it is important to know that the 401K plan can t be accessed easily until you reached the age of 59 ½. This fact is mentioned earlier, and I ve said there are some ways to withdraw the fund earlier than this age, but certain penalties along with the income tax are attached to it. Second, the 401K plans typically don t have the luxury of being insured by the Pension Benefit Guaranty Corporation (PBGC), but in other case, some pension plans available today don t enjoy this kind luxury either. The third and last disadvantage is that there is lesser chance for you to own the matching contributions placed by your employer as it is usual in the plan that the matching contributions are not vested until a number of years have passed. According to some resources, one rule in the 401K plan holds that the matching contributions must vest according to either a three-year cliff plan, or a 6-year graded plan. If your company has offered 401K, the management knows this for sure. The 401K retirement plan, although it comes with certain disadvantages, remains until now as an important part of retirement planning. With this, it is expected that those who may want to retire from work someday should learn and understand everything that they possibly can about the plan. Perhaps the most brilliant move you can take now is to gather information on everything that is related to the concept, such as vesting, contribution limits and matching funds. Once learned, keep track of your investments regularly and don t be afraid to ask for assistance. That s simply it!

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