A 401(k) is a retirement plan like an IRA, but instead of being a private plan it is sponsored by an employer. An employee can decide to open a 401(k) fund that is provided by her employer. The employee decides what percentage of her salary she will contribute to her 401(k) fund. When the employee’s paycheck comes, the proper amount is deducted from the paycheck and put into the fund before the paycheck is taxed.
Like an IRA, the investment put into a 401(k) plan grows over time, and after the employee has reached a certain age (usually 59 ½ years old), she can begin withdrawing money from the account. If the employee withdraws from the account before this time there is a penalty fee that must be paid.
Some of the benefits of opening a 401(k) plan include: free money from your sponsoring employer, a lower taxable income, and earnings that automatically accumulate. 401(k) plans are also very convenient, since money is automatically taken from their monthly pay.
401(k) plans may offer a variety of investment options, including:
- Stock mutual funds
- Bond mutual funds
- Stable value accounts
- Money market accounts
When investing it is always important to diversify so as not to place the majority of one’s assets in one mutual fund or account. One should also follow the 25% rule, whereby 25% of one’s investments are small-cap investments, 25% mid-cap, 25% large-cap and 25% international.
Some of the advantages of a 401(k) plan become relevant when you plan to use your growing investment to pass on to your family and other beneficiaries after you have died:
- Contributions to 401(k) plans are not subject to federal income taxes until distributions of the funds from the plan are made.
- Any gains and earnings in the investment are also tax deferred until distribution.
- Many employers will match contributions to the plan made by the employee.
401(k) plans these days tend to be portable, meaning that an employee may choose to take the funds in 401(k) and transfer them to an IRA. Depending on the type of IRA, these funds can then be passed to your beneficiaries through the IRA after you die, which will provide them with a source of liquid assets that could be used to pay off funeral expenses and immediate debts you have left behind.
Planning how your estate will be distributed and how your beneficiaries will be taken care of after you have passed on can be complex and full of options you may not fully understand. You may want to an estate lawyer with experience in estate planning. Your attorney will be able to help you understand what options are available to you, as well as the implications of all those options.