The 401K derives its name from the IRC (Internal Revenue Code) of 1978. It is administered by the EBSA (Employee Benefits Security Administration) of the Department of Labor.
The 401K plan has various advantages. First and most important is that the employee can contribute pre-tax money thus minimizing the tax paid in each paycheck. Moreover the company contribution and any increase in the fund does not attract tax till it is withdrawn.
The compounding returns from the fund for a period of 20-30 years are simply astronomical. An employee can play a major role in the direction of the future contributions. When the company contributions kick in, something additional is added over your own money. Unlike pension, all money in the plan can be switched over to another company.
The 401K plan is protected by pension laws because it is a personal investment plan. It includes protection against seizure by creditors but not against domestic cases like child support.
There are some drawbacks of the 401K plan, it is difficult to recover your 401K contributions before 60 years. The 401K is not assured by the PBGC (Pension Benefit Guaranty Corp). Besides company contributions do not set in till you have completed a fixed years of employment. As per the rules, company-matching contributions must either be a 3-year ‘cliff’ plan (100% after 3 years) or a 6-year ‘graded’ plan.
Employees participating in a 401K plan have various investment choices. In most cases, they are a whole lot listing of mutual funds. The mutual funds normally contain money market fund, treasuries, stock funds and bond funds. Certain plans can include investing in company stock and US Savings Bonds. The employee can decide on how the savings are invested. The employee can also decide at any instant, not to keep on contributing.
Financial advisers are generally of the opinion that the average 401K contributors is non-aggressive in their investment choices. Traditionally, stocks have outperformed other types of investment, and as since the 401K is a long-term investment it can reduce the stock market volatility.