401(k) retirement plans are popular investment vehicles for people that are employed. Employees can utilize employer sponsored 401(k) plans in order to invest regular amounts of their income into mutual funds, stocks, or bonds.
401(k) plans are straightforward investment structures for people who want to put money toward their retirement while they desire little involvement with investment decisions at the same time.
Essentials of a 401(k)
In a nutshell, 401(k) retirement plans offer employees the opportunity to invest a part of their monthly income in a mutual fund or stock (including company stock) and benefit from a payroll tax deduction in return.
Retirement savings contributions are not taxed at the time of contribution, which is a major benefit of a 401(k), but they will be taxed later on when funds are distributed.
401(k) plans are classified as defined-contribution plans meaning employees absorb the risk of their investments and their employer does not make a guarantee with respect to future pension payments.
Many employers, however, offer a 'matching contribution' which means that they will match any employee contributions, though this will likely be capped at some percentage of the employee's compensation.
Employees can usually withdraw their funds when employment ends and they enter retirement, when they reach the age of 59.5 years or the plan is terminated. Many 401(k) plans also include hardship conditions under which participants may access their 401(k) assets in times of extraordinary need.
If you like to read up on 401(k) plans, consider the resource guide from the Internal Revenue Service which has a bunch of helpful information and clarifies any further questions you might have.
Put simply: You are not required to pay taxes on your contributions now and you might get your employer to chip in via matching contributions. Sounds like a sweet deal.
Further advantages of utilizing the 401(k) route for retirement saving are presented below and employees are advised to take full advantage of this investment vehicle to build up their nest egg:
1. Compounding leads to higher capital returns
The biggest advantage a 401(k) offers is the feature of compounding.
This has profound implications for investors as their investment returns are not taxed during the life of the 401(k): Not having to pay taxes on investment returns translates into a higher asset base that continues to earn more money for the future retiree over time. This compounding effect works to the benefit of the investor and can lead to a portfolio that can accumulate quite substantially over long periods of time.
Employees should proactively talk to their employers and seek out their 401(k) offers. The maximum amount of compensation in 2014 that employees can defer stands at $17,500.
2. Structured approach to retirement planning
401(k) plans are a great concept to lend structure to your retirement planning. First of all, contributions to your plan will be made automatically and on a regular basis.
Secondly, employees and investors might find it a daunting task to decide what stocks or asset classes to invest in and at what times. Utilizing a 401(k) puts retirement planning on autopilot as investment decisions will no longer be a cause of worry for you.
3. Smoothing out volatility
Another convincing reason to invest in a 401(k) relates to smoothing out market volatility.
At any particular time, the stock market could tank and with it the value of your 401(k). If you make regular contributions via such a plan you will continue to make investments in stocks and mutual funds when their values are consolidating in a recession and are therefore cheap.
If you participate in your 401(k) retirement plan over many years, the inherent fluctuations of the stock market as well as the fluctuations in economic activity will balance out and work to your benefit.
The Foolish Bottom Line
401(k) retirement plans are great investment vehicles for employees who desire a structured, low-maintenance approach to retirement planning.
Understand that the major benefit of a 401(k) lies in offering you the benefit of compounding, which allows you to earn substantially higher returns over long periods of time.