What is a 401(K)?

PUBLISHED Oct 26, 2022, 1:13:21 AM        SHARE

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When you enter the working world or change your job, one of your first matters of business is setting up a retirement such as a 401(k) plan. But what exactly is a 401(k)? Let’s explore the answers to some common questions.

What is a 401(k)?

A 401(k) is a retirement savings plan sponsored by an employer that allows employees to save and invest a portion of their paychecks before taxes are deducted. Taxes aren’t paid until the money is withdrawn from the account.[1]

Why is it called 40(1k)?

401(k) is the tax code that governs this type of investment plan. 401(k) plans were created as supplements to pension funds that many employers offered in the past. Those funds were managed by the employer and paid out a steady income over the course of retirement.[2]

Why is 401(k) different and better than an IRA?

401(k) plans are workplace retirement accounts. Your employer may assist with contributions as a part of your plan. IRAs, or individual retirement accounts, allow account holders to own many different assets within the account, including stocks, bonds, certificates of deposit (CDs) and even real estate. Some assets, such as art, are not permitted within an IRA, according to IRS rules. 401(k)s are your better choice if you will receive assistance from your job to add to your retirement account balance.

Additionally, the maximum contribution for a 401(k) is much higher than an IRA. Current 2020 maximums are $19,500 for a 401(k) and only $6000 for an IRA.

What’s the difference between Roth and Traditional retirement plan?

Both IRA’s and 401(k)’s typically offer a Roth or Traditional option. The biggest difference between the two options is when you pay tax on the income you have contributed and if you will pay tax on the earnings.

With a traditional retirement plan, your contributions are tax-deductible in the year they are made. However, as you make withdrawals in retirement you will pay your current income tax rate at the time of the withdrawal.

With a Roth, your contributions are NOT tax-deductible in the year they are made. In short, you paid tax on the money before putting into your Roth retirement account. However, your withdrawals in retirement are tax-free. This includes any growth you have earned.

How do money savvy people make this work for them? Understanding the tax bracket you are in now and the one you might be in during your retirement, will help you to determine which is best for you. An example, for the younger generation that has a long time for their money to grow and is typically in a lower tax bracket, a Roth is a great option

How does the match work?

There are some great companies that will match whatever funds you place in your account. Here are the three most common types of contributions:

Matching contribution – your company matches the contribution that you make to your 401(k) account up to a specific threshold.

Partial contribution – your employer contributes a fraction of your contribution, and your employer’s total contribution is capped as a percentage of your salary.

Dollar for dollar – an employer’s contribution equals 100 percent of an employee’s contribution, and the employer’s total contribution is capped as a percentage of the employee’s salary.[3]

Where is the money typically invested, and is it safe?

Where your money is invested is up to your discretion in accordance with what your retirement plan offers. There are typically several options to choose from, including mutual funds. This is completely up to you and your financial adviser. There isn’t a one-size-fits-all here and your plan can be completely customized for your comfort.

What happens if you die?

When you set up your retirement accounts, the person you choose as your beneficiary will receive your retirement funds. (So make sure that you keep your beneficiary current.)

Now that you know more about 401(k)s, it should be easier to plan for your financial future. Feel free to consult with your financial advisers for further assistance.


1 https://guides.wsj.com/personal-finance/retirement/what-is-a-401k/#:~:text=401(k)%20plans%2C%20named,the%20course%20of%20the%20retirement
2 https://www.investopedia.com/ask/answers/12/401k.asp
3 https://www.forbes.com/advisor/retirement/what-is-401k-match/
Originally Posted on wealthyhabits.org

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