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What is a 401k and what are the Benefits of this type of Retirement Account

March 30th, 2006

What is a 401k and what are the Benefits of this type of Retirement Account


Your employer more than likely offers a 401k package.  You know it has something to do with retirement.  The 401k helps an individual save for retirement and usually there are some extra benefits offered by the company you work with.

The government wanted to get people to save for retirement.  In 1978, The Tax Reform Act was passed.  It gave people a way to lower their state and federal taxes and save for retirement at the same time.  The name 401(k) got its name from the Internal Revenue code from the section 401 and paragraph (k).  It wasn’t until 1982 when the 401(k) was offered for the first time with a tax break.  The final regulations for the 401(k) were completed in 1991.

There are other retirement plans available.  That is where some of the confusion begins; there are IRA’s SEP’s and money purchase plans along with the 401(k) plans.  These plans are also called a “defined contribution plan”, which means that the dollar amount is previously defined by either the employee or the employer.


It is common to find employers that offer 401(k) plans from a private sector corporation.  If you are self-employed you can set up a 401(k) plan for yourself.  If you are self employed you have more flexibility to the contribution amounts.  You can set up a 401(k) plan from many bankers, mutual fund, or insurance company.  The bank should have a person that specializes in retirement planning.  The banks would likely be the best to work with in setting up a 401(k).

The 401(k) when set up has an agreed amount “deferred” into the 401(k) account.  Once the funds are in the 401(k) account they are often able to be invested in a mutual fund.  If you work for a company this is usually set up for you on the choices for the investment options.  The mutual funds are usually a varying selection of stocks, bonds, money market investments.  There is also an option to purchase the companies stock which can be a risky investment.


There is a kind of 401(k) called a “trustee-directed” which means that the employer does all the decisions on how the assets will be invested.  The participant of these kinds of plans should be wary of this kind of investment.  The more common type of 401(k) plans is called “participant-directed plans”, which is the type that you should invest with as it gives you the control.

Companies may try to keep employees by offering a match in the contribution that the employer makes to the 401(k) plan.  This job benefit may help to keep employees loyal to working for that company.

What happens when you quit or get fired from a company and you have a 401(k) plan?  You are able to keep the 401(k) account with the company and it should stay active, however some companies will charge a fee for the ex-employees.  You can transfer your 401(k) to another account.  It is called a “roll over”.  You can also transfer the 401(k) into and independent IRA with a financial institution.


There are perks to the 401(k) because of the amount you can deposit in the account, along with some companies matching your contributions up to a certain dollar amount.  You get a tax break, which can lower your tax bracket and save you a bundle on your income taxes.  If you are self-employed and want a tax break this can be a strategy that your tax advisor can help you with.  You have to set up a 401(k) with the money invested into the account by December 31st for the discount on that tax year.

When you reach the age of 70 ˝ years of age you have to start taking out the funds.  You pay taxes on the money that is taken out of the account.  The benefit of a 401(k) is best started by a younger individual.  The longer your investments have to make a profit the more financial gain you have.  The 401(k) is not taxed when it is in your account, so all the profits that you receive and reinvest are not taxed until in comes out after you retire.

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