401(k): The ‘Standard’ Employee Retirement Plan
- An easy option if you’re an employee
- Employer matching contributions
- High contribution limits
- Limited investment options
- It may take several years before you fully own your employer’s matching contributions
If you’re an employee, your employer’s 401(k) could be a very convenient retirement plan option since companies usually strive to make them easy to set up and manage. A 401(k) is a retirement plan offered by many for-profit companies as an employee benefit. Generally, you can contribute simply by diverting part of your paycheck into the retirement plan.
Like most other types of retirement plan, a 401(k) provides tax advantages by reducing your taxable income. For example, if you earn $60,000 in one year and contribute $5,000 to a 401(k), you won’t pay income tax on the portion you contributed.
Tax-free growth. The money in your 401(k) grows tax-free until you choose to withdraw it, at which time you’ll pay income tax on the money you take out. As with most other types of retirement plan, you have to be 59½ or older to withdraw money without penalty, and you’re required to start withdrawing money at age 72.
Matching contributions. A big attraction of 401(k) plans is that many employers provide matching contributions when you put money into the plan. That’s potentially free money. The catch: you may only earn the employer-contributed portion over several years (a process called “vesting”). If you leave the company before becoming “fully vested,” you’ll keep all your contributions but may get only a portion of your employer’s contributions. If you switch employers or retire, you can “roll over” your contributions to another company’s 401(k) plan or another type of retirement plan.
High contribution limits. Another attraction of 401(k) plans is the relatively high contribution limit: you can contribute up to $20,500 in 2022, or $27,000 if you're 50 or older. The total contribution limit, including both employer and employee contributions, is $61,000 (or $67,500 for over-50s).
Limited investment choices. A disadvantage of 401(k) plans is that you usually have a limited number of investment choices within the plan, such as mutual funds.