Investing Through Your 401(k)
A Beginner's Guide to the Different Types of 401(k) Plans
If you have ever asked yourself, "What is a 401(k) plan?", the short, simple answer comes down to this: A 401(k) is not an investment. It is a type of account that has special benefits that allow you to build wealth by investing in 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.
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 inventions is the Roth 401(k). This special type of 401(k) has many of the same benefits of a Roth IRA. It means that you contribute money to the plan and don't get to write the contribution off your taxes, but 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 In a traditional 401(k), in contrast, contributions are tax-deductible, and you only pay taxes when the money is withdrawn.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). A relatively new type of retirement account, it has many features that may make it more attractive to small business owners than the (currently) more popular SEP-IRA.
When you invest 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 / Wal-Mart or an Enron / 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.
What Happens When I Leave My 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. To learn more about this special feature, read Understanding Your Rollover IRA.