People become increasingly anxious about the post-retirement days as they grow older, especially about the financial aspect of the retired life. Luckily, there are multiple retirement plan options available that can help people live a stress-free life in their golden years. If you’re considering a retirement plan, you’ve likely heard of the most popular option—the 401(k). Wondering what it is, how it works, and its features and drawbacks? This article touches on all these topics!

How a 401(k) retirement plan works
Employers offer 401(k) retirement savings plans to their employees, wherein the latter agree to contribute a portion of their monthly salary into a long-term investment account. In some cases, the employer may match a portion or entire amount of the employee contribution, i.e., the company will put in money too. The employee gets to choose the type of investment option they want to put their money into, as well as the amount. A 401(k) retirement plan was made to help people save for retirement. Since the plan gives employees a tax break on the money they contribute and has other benefits, many employees sign up for a 401(k). However, not all companies in the country offer the plan yet.

Types of 401(k) retirement plans
The main types of 401(k)s primarily differ on the basis of how they’re taxed; these types are

Traditional 401(k)
A traditional 401(k) allows employees to contribute a portion of their paycheck before it’s taxed. Consequently, employees reduce their taxable income immediately, and the contribution grows in value over the years. However, employees are required to pay tax at the time of withdrawal. The traditional 401(k) is a go-to choice for many people who wish to retire in a lower tax bracket.

Roth 401(k)
In Roth 401(k)s, also known as designated Roth accounts, employees put in their after-tax dollars. This plan doesn’t immediately lower an employee’s taxable income, but it allows them to make tax-free withdrawals. The tax-free withdrawal includes all the money their contributions earn over the years sitting in the investment account. A Roth 401(k) plan is an excellent option for those who wish to retire in a higher tax bracket.

If an employer offers both traditional and Roth 401(k), employees may have the option to split their contributions between both. Since predicting future tax rates is almost impossible, diversifying your contributions is a prudent step.

Features of a 401(k) retirement plan
Here are the key features of a 401(k):

Contribution limits
The amount you’re allowed to put into a 401(k) is limited by the IRS, and that limit can change according to inflation. As of 2022, the IRS has capped the annual employee contribution at $20,500 for those below 50 years of age. Employees who are 50 or older can put in an additional $6,500.

Employer contribution and matching
Companies may choose to contribute and match to their employees’ 401(k) plan, mainly to encourage employees to save for their retirement. For deciding the contribution amount, different companies use different formulas. For example, some employers match “dollar for dollar,” which means your employer also puts in 6% you do.

Option to roll over a 401(k) account
If you resign from your current employer, you may have the option to roll your savings to your new employer’s 401(k) plan. In addition, you have three options: moving your money into an Individual Retirement Account (IRA), keeping it with your current employer, or withdrawing the whole amount. Consult with your financial advisor to determine which option might be best for you.

Drawbacks of a 401(k) retirement plan
Some drawbacks to having a 401(k) include

Limited investment options
A 401(k) retirement plan typically allows employees to invest their money into basic assets like stocks, bonds, and cash funds. These investment options are few compared to other types of retirement accounts, such as an IRA or a taxable brokerage account.

Higher account fees
Operating a 401(k) retirement plan isn’t free as it usually comes with fees for administration, investment, and service. These fees tend to be higher in smaller companies as they usually have few participants and few assets to spread the fees across.

Penalties for early withdrawals
If you want to withdraw your savings before reaching the official retirement age of 59 and a half, you’re likely to incur a 10% penalty. A 401(k) is generally profitable for those who don’t need to use their savings anytime soon.