401k is a kind of retirement plan that contributions made to the account do not attract any tax until withdrawal. The plan is applicable to both profit making organizations and non-profit making organization. In most cases, the employer also contributes to this account on top of an employee’s contribution to the account. The amount contributed to the account is referred to as a mutual fund; it is invested in stocks, bonds, money markets and unit trust or a mixture of any combination of these options. A contributor to the account has the option to manage their own the investment portfolio or appoint a trustee who manges the fund on their behalf (Spiceland et al, 2007, p. 2).
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However, 410k has some numerous disadvantages. When a 401k account holder decides that his account should be managed by a trustee, one loses the control over the funds. One is only made aware of the progress of the funds after some time, normally after four months. Slesnick and Suttle (2007) stated that “the lack of direct control makes an account holder to have little or no influences on the direction the investments take” (p. 62).
Another disadvantage of 401k is the limited available options of investment portfolio that an account holder can take. The options are stocks, bonds and mutual funds. There is a restriction in investing the accounts funds in real estate, partnerships, private business, private capital and many more options. This restriction brings about an opportunity cost to the account fund as other options may have a higher rate of return than any arrangement of the stipulated options.
Most 401k arrangements are connected to the employer’s corporation the decisions made are not always directed to the benefit of the employee. An employer may affect benefits accruing to the employee if they decide to change the company managing the accounts or switch between different 401k plans. Incase of such an arrangement, an account holder’s priorities are not considered while making such decisions. The 401k plans may be organized in a manner that gives the employer many benefits than the employee. This is normally revealed on the investment resolution taken.
401k plans can either be self directed or trustee directed. Though the self directed accounts appears to have some advantages since the account holder has the chance to control and chose the investment choices, the account may have some restrictions. The restriction could be on a limited amount that is at the discretion of the account holder for personal investment control.
401k plans have restrictions on the withdrawal of money from these accounts. Incase one withdraws the money he/she must payback. There are restrictions to withdrawal of the money before the age of 59 and half years. There is a heavy penalty of about 10% imposed if one withdraws money from the account before the stipulated age. One is also forced to withdraw all the money at the age of 70 and half years not unless one is still working. Contribution to 401k account is restricted to a limit of $10,500 per year. Both personal and the employer’s contribution are restricted to this amount. Further restriction is an upper limit of 25% of gross salary, incase ones quarter of their salary is bellow the $10,500 level they are bound not to contribute more that 25% of their gross salary. Traditional 401k plans restricts contribution by employees until they have reached a certain number of years.
Lange (2009) states that “contributions to 401k account are tax exempt at the time of contribution but are subject to taxation at withdrawal time” Since tax laws and regulations keep on changing there is a possibility that the amount of tax paid could increase incase tax rate increase in the future compared to contribution time. Such a scenario would be disadvantageous to the 401k account holder since the amount of tax paid in the future is more than the tax that would have been paid if a taxed during contribution (p. 39).
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Pension plans can either be in form of social security, employer full sponsored pension or individual saving plans. These pension plans are either defined benefit plan or defined contribution plans. There are advantages and disadvantages of pension plans over 401k. Incase of defined benefits plan the employee in most cases does not contribute any amount towards the pensionable amount. Contributors to a pension plan usually have a better chance to control the type of investment their funds will be invested in besides having a wider variety of choices to make for their investment. Incase of defined contributions one may use personal income to contribute to the pension fund and one is not restricted in the amount he/she can withdraw before retirement age. Slesnick and Suttle (2007) pointed out that incase of defined benefit pension plan there is “guaranteed money entitlement upon retirement and there is no risk involved in making unprofitable investment decisions on the pension money before maturity” (p. 57).
Pension plans have a number of disadvantages over the 401k retirement plans. Pensions plans may fail to invest inopportunity that have the highest returns there by incurring some opportunity cost, this makes a person to lose out in the pension money by being entitled to a smaller amount. Most of the pensions plans have the restriction of withdraw of the money after retirement. This makes a person in need of money to be denied the chance to use them until retirement. There is a general tread among the employers shifting from guaranteed pensions to the contribution pensions plans; this has made them to be so limited and scarce (Spiceland et al, 2007, p. 45).
Both pension plan and 410 retirement plans have their advantages and disadvantages but it is upon an individual to decide at the best option to take. Again depending on the employer policy an employee may decide to make the most appropriate investment mix in order to rip maximum benefits from the contributions to a pension’s fund.
Lange James (2009). Retire Secure: Pay Taxes Later – The Key to Making Your Money Last. Hoboken, NJ: John Wiley and Sons.
Loeper, D. B. (2007). Stop the 401(k) Rip-off: Eliminate Costly Hidden Fees to Improve Your Life. Austin: BookPros, LLC.
Salisbury, D. L., Jones, N. S. Employee Benefit Research Institute & Education and Research Fund (1994). Pension funding & taxation: implications for tomorrow. Washington, D.C: Employee Benefit Research Institute.
Slesnick, T., & Suttle, J. C. (2007). IRAs, 401(k) s, & other retirement plans: taking your money out Berkeley: Nolo.
Spiceland, J. D., Sepe, J. F., & Tomassini, L A. (2007). Intermediate Accounting (4th Ed.). Boston, MA: Mc Graw-hill.