Investing Through Your 401(k)
A Beginner's Guide to the Different Types of 401(k) Plans
A 401(k) retirement plan is an employment, tax-advantaged, benefits program. The plan carries a defined contribution from both the employer and the employee. It is not an investment. It is a type of account that has special benefits that allow you to build wealth by investing in employer-determined plan assets such as mutual funds, stocks, index funds, and real estate investment trusts.
There are several different types of 401(k) plans, each with unique advantages and drawbacks ranging from tax rules to bankruptcy protection. Some of these plans include the traditional 401(k), a self-directed plan, a safe-harbor plan, a SIMPLE 401(k), Roth 401(k), and the tiered-profit sharing plan structure.
If you work for a government agency or non-profit, you will not be eligible for a 401(k) account. Instead, you might have something known as a 403(b) plan.
The Roth 401(k)
One of the newest versions of these retirement plans is the Roth 401(k). This special type of 401(k) has many of the same benefits of a Roth IRA. You contribute money to the plan and don't get to write the contribution off of your taxes. Roth plans are funded with after-tax dollars—taxes were deducted from your paycheck before the contribution was taken. You'll never pay a penny in income tax or capital gains tax on the money—even if it grows to tens of millions of dollars—by the time you retire.
In a traditional 401(k), in contrast, contributions are tax-deductible, and you only pay taxes when the money is withdrawn.
The Small Business 401(k)
For small business owners or those who work for themselves, a great choice might be a Self Employed 401(k)—also known as a solo 401(k). These are a relatively new type of retirement account, it has many features that may make it more attractive to small business owners than the more popular Simplified Employee Pension Individual Retirement Arrangement (SEP-IRA).
Owners make contributions with pre-tax dollars and allowed to grow tax-free until they are withdrawn during retirement. The IRS has limitations on the amount a self-employed individual can contribute to the plan.
When you choose the investments through a 401(k) account, there are several risks you want to try and reduce. These include:
- Investing in Your Employer's Stock: How do you know if your employer is a McDonald's or a Wal-Mart and not an Enron or a Worldcom? The first two made their employees extremely wealthy, whereas the last two experienced total and complete wipeouts.
- The risk of putting too much money into your 401(k) account at any one time. It can be reduced by a practice known as dollar-cost averaging.
- One of the most common questions we are asked is: Should You Take a 401(k) Loan? The answer depends upon a variety of circumstances, and there are benefits and risks.
- Another question we often receive is whether or not you should continue to contribute to your 401(k) account based on market levels, job prospects, or any other number of factors. In a special article, Never Stop Contributing to Your 401(k), we explain why that philosophy can be an expensive mistake.
401(k) When You Leave Your Job
You have several options for your 401(k) when you leave a job. The most attractive is often something known as a Rollover IRA that allows you to take the money in your 401(k) and keep it protected in a tax-sheltered account.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.