A 401(k) plan is a tax-advantaged plan that offers a way to save for retirement. An employee contributes to the plan with pre-tax wages, meaning contributions are not considered taxable income. The 401(k) plan allows these contributions to grow tax-free until they’re withdrawn at retirement. At retirement, distributions create a taxable gain, though withdrawals before age 59 ½ may be subject to taxes and additional penalties.
Pros: A 401(k) plan can be an easy way to save for retirement, because you can schedule the money to come out of your paycheck and be invested automatically. The money can be invested in a number of high-return investments such as stocks, and you won’t have to pay tax on the gains until you withdraw the funds. In addition, many employers offer you a match on contributions, giving you free money – and an automatic gain – just for saving.
Cons: One key disadvantage of 401(k) plans is that you may have to pay a penalty for accessing the money if you need it for an emergency. While many plans do allow you to take loans from your funds for qualified reasons, it’s not a guarantee that your employer’s fund will do that. Your investments are limited to the funds provided in your employer’s 401(k) program, so you may not be able to invest in what you want to.
What it means to you: A 401(k) plan is one of the best ways to save for retirement, and if you can get bonus “match” money from your employer, you can save even more quickly.