What is 401K plan and how does it work?

Last Updated: 28 Jun 2024

If you are concerned about your retirement planning then you have surely heard of 401K! This is unique to the United States but remains a global benchmark as far as retirement planning is concerned. So, what exactly is Section 401K and how does it work? Here is a quick guide to the 401K plan.

What is the 401K plan all about?

A 401(K) plan is popularly known as an employer-sponsored retirement plan to which certain eligible employees based on pre-set criteria can make tax-deferred contributions from their salary or wages. Like the EPF contributions in India, in the 401K plan also the employee and the employer (the company) contribute to the plan. But there is a difference here. In India, the employer contribution and the employee contribution to EPF is tax free in the hands of the employee. However, in the 401K plan, only the employee contribution is tax free. In other words, the employee contribution is post tax while the employer contribution is pre-tax.

Employers offering a 401(K) plan may make matching or non-elective contributions to the plan on behalf of eligible employees and are also permitted to add a profit-sharing feature to the plan. Like in the Indian EPF plan, the benefits of 401K are also tax deferred that means the full benefits are only realized at the time of retirement and regular payments are credited to the plan and cannot be withdrawn. Hence, the tax burden you’ll incur varies by the type of 401(K) and on how and when you withdraw funds from it.

Why are 401K plans popular in the United States?

There is no gainsaying the fact that the 401K is extremely popular in the US. Look at the numbers! Out of the total retirement corpus in the US amounting to $28 trillion, nearly 1/5th is parked in 401K accounts. This not only permits employees to save for their future in a tax efficient manner but also helps them to participate in equities for long term wealth creation. Currently, there are more than 5.5 crore American workers who are active participants in their employers’ 401(K) plans. The fact that over 2.5 lakh businesses in the US (including most of the Fortune 500 companies) use this plan extensively is evidence of its popularity.

The average 401K plan is highly flexible in terms of choices and offers nearly 25 different investment options. In the past, the fund fees used to be a major issue but that has been consistently coming down reducing the burden on the retirement corpus of employees. In fact, the rapid rise of passive index funds in the US like Vanguard and Blackrock are attributed to the contributions to 401K, which put a good amount of money in these index funds as low cost and low risk methods of participating in the equity markets. Apart from offering employees a low-cost avenue to save for the future, 401K contribution limits are indexed to inflation which allows participants to make larger contributions over time.

Key challenges for the 401K plan

The 401K, despite its popularity and its massive assets under management, has some key limitations which employees must be wary of. Here are a few of them.

Since the 401K is a defined contribution plan, the onus of bearing the investment risk entirely falls on the employee; quite often they are not prepared for the same.

Remember that 401K is not a guaranteed plan as the pension will be based on the amount of cash in the fund at time of the employees retirement.

The 401K plans may be left with big shortfalls since a major portion of the corpus is still in debt and bond yields have been falling rapidly since 2008.

Lastly, liquidity remains a major challenge in the 401K plans. You really cannot rely on this corpus for emergency fund requirements and that has to be separate.

In India, too much of long term money is unproductively going into debt and too much of short money into equity. Perhaps, 401K type plans can change that!