What Is the Purpose of 401(k) Retirement Plans?


Quick Answer

Funding a 401(k) saves money for retirement and lowers income taxes with minimal decreases to take-home pay. A 401(k) is an investment account that corporate employers offer to employees, but an outside financial firm, such as Fidelity or Vanguard, manages it, states CNN Money.

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Full Answer

To fund a 401(k), an employee decides the contribution amount, and the employer puts it into an investment account through a payroll deduction. When enrolling in the plan, the employee chooses a percentage of salary to use. Some employers match the contribution with a certain amount of money for every dollar the employee places in the account; however, the employee decides the type of investment, with mutual funds being the most common choice, reports CNN Money.

Employees make contributions with pretax dollars, which means withdrawals from pay checks occur before taxes are deducted. As such, a salary deduction of $100 per month placed into a 401(k) typically reduces a pay check by approximately $60 to $80 per month. Plan holders pay regular income taxes when they withdraw money from the 401(k) at retirement. There are penalties for withdrawals before 59 1/2 years of age, states CNN Money.

While corporate employers sponsor 401(k) plans, employees bear the risk of investments. For long-term retirement goals, stocks typically generate returns that outpace inflation. A portfolio that also includes bonds and cash reduces volatility, states CNN Money.

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