A Beginners Guide to Understanding 401k Retirement Plan

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A Beginner's Guide to Understanding 401k Retirement Plan

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  • 11th Mar 2021
  • 2,620

A Beginner's Guide to Understanding 401k Retirement Plan

A 401(k) plan is one of the most popular retirement plans. Even though the plan is unique to the United States of America, it is considered a global benchmark in retirement planning. Moreover, Non-Resident Indians (NRIs) who return to India after working in the U.S. usually have a 401(k) plan that they need to take care of.

So, here is a quick guide to help you understand 401(k) retirement plans:

What is a 401(k) plan?

A 401(k) plan is an employer-sponsored retirement plan which allows eligible employees to make contributions. The contributions are deducted from the salary or the wage of the employee. And like an Employee Provident Fund (EPF) in India, the employer also matches the employee contribution to the plan up to a specific limit. However, in India, EPF is tax-free at the hands of the employee. But in a 401(k) plan, only employee contribution is tax-free, and employer contribution is considered pre-tax.

Besides, like an EPF plan, 401(k) plan contributions are also tax-deferred. This implies that the contributions made to these plans and their investment earnings are taxed as ordinary income during withdrawal. That said, withdrawals from a 401(k) account are allowed after the employee is 59.5 years old. Any premature withdrawals result in a penalty of 10% on the sum withdrawn, in addition to the regular income taxes.

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How does a 401(k) work?

The employer-sponsored 401(k) plan allows employees to decide the amount they wish to contribute, and the same is deducted from their paycheck every month. The money deducted is further invested in a chosen plan for the long-term. This retirement plan allows employees to invest in stocks, bonds, mutual funds, etc.

In an EPF, employees contribute a defined share of their salary and the same is contributed by the employer.

What are the contribution limits of a 401(k)?

For 2020, the maximum contribution to a 401(k) account is $19,500. However, for 50 years or above age employees, an additional catch-up contribution of up to $6,500 in 2020 is permitted. These limits are expected to remain the same for 2021 as well. In the case of joint contributions, including employer and employee, the upper contribution limit is $57,000 for 2020 and $58,000 for 2021. For those 50 years or older, the limit is $63,500 for 2020 and $64,500 for 2021.

As per EPF rules, all employees earning more than ₹15,000 have to contribute 12% of their wage plus dearness and retaining allowance towards EPF. The employer contributes the same percentage. The employee can also choose to increase the contribution percentage. That said, for establishments that have less than 20 employees, the contribution rate for both employer and employee is 10%.

Key challenges of a 401(k) plan

Despite its popularity, 401(k) plans are not the ideal retirement plans, because:

  • These are defined contribution plans, and hence, the investment risk is largely borne by the employee.cccc
  • Limited investment options restrict the potential return on funds.
  • These are not guaranteed plans, and the pension is based on the balance in the account at retirement.
  • These plans are not ideal for emergency usage since they have low liquidity and strict withdrawal rules.

Overall, 401(k) plans in the USA or EPF plans in India are standard plans that are beneficial for retirees only if clubbed with other wiser retirement plans like Kotak Lifetime Income Plan and Kotak Premier Pension Plan. The former assures lifetime income while the latter allows retirees to accumulate significant retirement corpus with assured benefits on death and vesting. Make an informed choice!

- A Consumer Education Initiative series by Kotak Life

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