Why is a 401(k) the Most Popular Investment Option in the United States

The 401(k) is one of the most popular retirement investment options in the United States. As of 2014, combined 401(k) plans held nearly $4.4 trillion assets, representing 18% of all retirement assets in the US. Nevertheless, many Californians still don’t fully understand the benefits and limitations of having a 401(k) plan. Additional information is needed so that individuals are able to take full advantage of this retirement investment option.

The 401(k) is an employer-sponsored retirement option that came into existence in 1978. Unlike the Roth IRA or the traditional IRA, 401(k) eligibility is limited to employees whose companies establish these plans as an employer-provided benefit on their behalf. Frequently, employers go a step further by matching their employees’ contributions to varying degrees. These matching contributions usually vest over time. For example, one large employer agrees to “match up to 50% for all employee contributions not exceeding $5,000.” This means that the employer will pay in up to $2,500 into the employee’s 401(k) account, provided that the employee pays in $5,000. An employee that pays in $1,000 will only receive $500 in matching contributions and an employee that pays in $10,000 will still only get $2,500. Employer contributions typically include vesting schedules, for example “20% per year of service, fully vesting after 5 years of service for the company.” This means that the employee will only realize 100% of the employer-provided matching contribution if he or she stays with the company for 5 years. If he or she quits after 3 years then he or she will receive only 60% of that sum. Matching contributions can be deposited by the employer with each paycheck, monthly, or as infrequently as once per year in one annual sum.

The key advantage of the 401(k) is that the employee does not pay federal incomes taxes on any amount for the current year. The employee is still responsible for payroll taxes. In addition, 401(k) distributions during retirement are taxed at standard income tax rates. Therefore, an employee is effectively choosing to pay taxes during retirement, when income levels are typically lower, verses during employment, when income levels are typically to be higher. Notwithstanding, investors should note that current US effective tax rates are some of the lowest in the modern era, and differing tax obligations may ultimately result in a higher tax obligation. As of 2015, the individual annual contribution limit into a 401(k) account is $18,000. Employer matching contributions do not count towards the limit. In addition, employees age 50 and older are allowed “catch up” contributions of another $6,000 per year (as of 2015). Any early withdrawal of 401(k) contributions is subject to normal taxation plus an additional penalty of 10%. The IRS allows for some hardship exceptions to the 10% penalty, such as unreimbursed medical expenses.

Many 401(k) plans come with high administrative fees that compound over time. Before investing, an employee should carefully research all available investment choices and only select lower fee funds.

Remember that this article is for informational purposes only. Always consult an attorney or your financial advisor (or both) before making any investment decisions.

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