Basics of 401(k) Retirement Plan

Planning for retirement is very essential for an NRI especially. An NRI has more options to choose from than most residents in India. So, they need to make wise decisions and choose the right plans while preparing for their retirement.
One such retirement plan is the 401(k) plan which is not applicable for Indian residents but only for USA-based Non-Resident Indians (NRIs). 401(k) is an employer-sponsored retirement investment and savings plan that works only in the United States.

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In this article, you will get to know all about the 401(k) retirement plan and how it can benefit you.

What Is 401(k)?

A 401(k) plan, popularly known as an employer-sponsored retirement and investment plan named after a section of the United States Internal Revenue Code. It is a defined contribution plan, which means it is completely up to the will of the employee as to how much they are willing to contribute to their account, subject to annual limitations.

Contributions made by the employee are directly withdrawn from their 401(k) account and invested in the funds of their choice. Employees can invest the money saved in their 401(k) account in one or more mutual funds offered by the plan.

How Does 401(k) Work?

 In general, there are 2 types of accounts under the 401(k) plan, mainly differentiated based on how they are being taxed.

Type 1

Type 2

Traditional account

Roth account

These are funded by pre-tax income

These are funded by post-tax income

Traditional Vs Roth Account

Traditional account

Roth account

Launched in 1978

Launched in 2006

Suitable for employees in a lower marginal tax bracket

Suitable for employees with a higher tax bracket

Employees near the age of retirement should go for traditional account

Young employees with low salaries now but likely to rise substantially in the future should go for Roth account

Advantage of an immediate tax break

Advantage of avoiding taxes later

Under a traditional account, you deduct contributions now and get tax-free withdrawals later

Under Roth account, you pay taxes on the contribution now and get tax-free withdrawals later

Functions like personalized pension account

Functions like a regular investment account

No age restrictions

No age restrictions

Penalty and tax-free after 5 years and age 59.5 years

Penalty-free but taxed as current income after the age of 59.5 years

No mandatory distributions required

Mandatory distributions after the age of 72

Tax-free withdrawals in the future

Advantage of tax benefit since the day of purchase

401(k) Investment Options

A typical 401(k) plan offers a wide range of investments, but any single plan might or might not offer all possible types of investments.

Even though a 401(k) investment plan comes with a variety of options like:

  • Company stocks
  • Individual stocks
  • Bonds
  • Securities
  • Variable annuities and much more.

Still, the one that rules the 401(k) investment opportunities is Mutual Funds.

Types Of Mutual Funds Under 401(k) Investments

Mutual funds are the most common 401(k) investment options. The most common Mutual Funds investment options include:

Mutual Funds

Features

Stock mutual funds

May have specified themes, such as value stocks or dividend stocks

Bond mutual funds

May feature specific kinds of bonds, such as short-term or intermediate-term

Target-date mutual funds

Includes both, stocks and bonds. Allocation keeps shifting based on specific target date or based on your retirement plan

Stable value mutual funds

Investment is made in safe assets, such as medium-term or government bonds. Returns and principal are insured against loss. Beneficial for investors near retirement

Range Of Mutual Funds Under 401(K) Investments

The abovementioned mutual funds range from conservative to aggressive, along with many grades in between. All the major financial companies use these similar terms while talking about the Mutual Fund range.

Let us look at the different range of fund types offered under 401(k) investments

Fund Types

Features

Conservative Funds

Avoids risks
invests in high-quality bonds and other safe investments
money grows slowly
minimal chance of facing loss
stable value funds come under conservative funds

Value Funds

The fund is in the middle of the risk range
invests in solid, stable corporations that are undervalued
companies usually pay dividends
growth is expected moderately

Balanced Funds

Funds include more risky equities
mostly includes value stocks and safe bonds
balanced means medium risk involved in investment holdings

Aggressive Growth Funds

As the name suggests, funds include high risk-taking value
funds can swing between high profits and great losses
suitable for people willing to take the extra risk and have huge capital to invest

Specialized Funds

These are the funds investing in emerging markets, utilities, new technologies, or pharmaceuticals

Target-Date Funds

Includes both, stocks and bonds
allocation keeps shifting based on specific target date or based on your retirement plan
intends to maximize investment at a particular time
investment moves towards the conservative end of the investment

How To Build 401(k) Portfolio?

Instead of investing all your money in one particular fund, it is always considered better to allocate your money around different funds. Allocation of money in different funds increases the probability of better returns. However, it is up to you to decide where and when to invest.

Here are some of the key factors that should be considered before you invest in a 401(k) plan

  1. Financial Goals

    It is important to differentiate between how much money you are willing to invest and take the risk upon. The sooner you start investing, the less you have to save to reach your goals later in life.

  2. Diversification Of Funds

    Diversification helps in capturing better returns in the end. Investing in mixed investments like stocks, bonds, commodities, and others, while maintaining balance is the best way to diversify your portfolio.

  3. Assessing Risk Tolerance

    One should always plan to take risks suitable to their portfolio. Higher the risk, more chances of profits and losses equally.

  4. Time Horizon

    More time until you need the money means you can take more risks and generate higher returns. This means that you should invest in such a way that you have ample time to recover if at loss.

  5. Minimize Expense Ratio

    You should avoid buying funds with high fees. It is always recommended that in case of options available, one should opt for the lowest cost option, which is an index fund.

The Bottom Line

401(k) retirement plan is beneficial not just at the time of retirement but throughout. It is an investment option that can help you not just to save your money but also grow it over years.

As the 401(k) investment plan comes with dynamic features and benefits, you need to make a wise and informed decision to avail of maximum benefits at the end.

Written By: PolicyBazaar - Updated: 01 September 2021
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