What is a 401k Account? How it works, Pros and Cons

Can you tell me about a 401k?

A 401k is a tax deferred account offered by employers as a part of their benefits package, through which you can invest money for your retirement.

Since these are offered by employers, you can open a 401k account only if your employer offers it.

How does a 401k work?

You decide how much of your income you want to set aside for 401k, and the amount gets withheld from your paycheck and gets deposited in your 401k account.

You then choose how to invest this money.

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Can I invest the money in my 401k account into anything?

No. Your employer offers a specific set of investment options from which you have to choose.

These options usually include various mutual funds or index funds, which may be investing in stocks or bonds, within the US or internationally, etc. The options could also include lifecycle funds, or target date funds, that are designed specifically for retirement planning.

How much can I invest in a 401k account?

The government decides the maximum amount that can be invested in a 401k account, and it changes from one year to another based on inflation.

For 2020, the 401k contribution limit is $19,500. People over the age of 50 can invest another $6,500 as a catch-up contribution.

What are the advantages of a 401k account?

The biggest benefit of a 401k account is employer matching. This means your employer also contributes money to your 401k for every dollar you contribute, up to a certain percent of your paycheck. This is essentially like getting free money from your employer!

Another big advantage of a 401k account is tax deferred investment. Your 401k contribution is pre-tax, which means you don’t pay income tax on the money you contribute. This reduces your tax for the year in which you make the contribution.

Your investments also grow tax free, and you only pay taxes when you withdraw money from your 401k account.

Are there any disadvantages of 401k accounts?

One disadvantage of a 401k is that the investment options are limited and defined by your employer, like we discussed earlier.

Another disadvantage of 401ks is that the money gets locked-in until your retirement – usually, any withdrawal before the age of 59 ½ incurs a penalty. But this isn’t necessarily bad, as it ensures that you are able to take advantage of the power of compounding while deferring payment of income tax, which can maximize your retirement savings.

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