Many people when starting a new job are asked by their employer if they would like to participate in the 401(k). But what exactly is a 401(k)? Should you use it? How does it work? Those are common questions many people have, and we’ll explore some of the answers below.
What is a 401(k)?
Simply defined, a 401(k) is a retirement savings tool that an employer can provide as a benefit to help their employees save for retirement. The name 401(k) is derived from the location in the U.S. tax code where the IRS outlines the rules and requirements for this type of retirement plan.
How does it work?
If you participate in the 401(k) plan, your employer will take money out of your paycheck and contribute it to your account. The benefit of taking home a smaller paycheck is that the money you contribute goes in without being taxed and does not get taxed until you take the money out, presumably years later. You are essentially making a deal with the IRS where they say that you will not get taxed now on the money contributed, or any of the growth in the account, but they will tax you later when you start withdrawing the money, normally in retirement. When you are working you are generally in a higher tax bracket, so you can put money away that is not taxed yet when you would owe a higher percentage for taxes and take the money out later when in a lower tax bracket.
What are the investment options?
Each employer sets up their 401(k) independently through a plan sponsor (the company that administers the 401(k) plan). Therefore, each employer plan is going to have different investment options depending on the agreement between your employer and the plan sponsor. Each plan has a set number of investment options that you would have access to which generally consist of various mutual funds that will invest in stocks, bonds, or cash.
Does my employer contribute to the 401(k)?
Generally, your employer will match a portion of your contributions into your 401(k). A typical amount would be dollar-for-dollar up to 3%, but it could be higher or lower depending on the employer. Using a dollar-for-dollar 3% match as an example: if you are earning $100,000 per year and are putting in 3%, you would contribute $3,000 per year into the 401(k). Your employer would match this amount and put in $3,000 on your behalf. If you contribute 10%, you would be adding $10,000 annually, but your employer would still only be adding $3,000 (the 3% match). However, if you only contribute 1% ($1,000) your employer would only add $1,000.
Another factor, called ‘vesting’, relates to when the company’s matching amount becomes yours. Often times you must stay with the company for a set number of years before you are entitled to take the matching amount with you if you leave the company. If you don’t stay the specified number of years you may forfeit some, or all, of the matching money. Your contributions are always considered 100% vested.
When can I take out the money?
A 401(k) is designed as a retirement savings vehicle, and as such, the IRS penalizes withdrawals before age 59.5. Also, in-service withdrawals are frequently not allowed (this is specific to your company plan). There are certain situations where you may be able to take funds sooner, but they are subject to specific rules.
Should I participate in my 401(k)?
It is recommended that you contribute at least up to the employer match. Otherwise you’re leaving free money on the table! Amounts higher than that will depend on your specific situation and what you can afford (since the money is difficult to access before retirement). There are other savings vehicles, such as an IRA/Roth IRA, that would give you more flexibility and control over the investments in the account which may be more appropriate, but more on that in another blog article.
Summary:
- A 401(k) is a retirement savings vehicle sponsored by your employer
- You contribute money from each paycheck into the account with money that has not yet been taxed
- Withdrawals from the account (ideally in retirement) are taxed as income then
- Withdrawals before a certain age are subject to tax and penalties (and may not be allowed at all)
- Your employer likely has some sort of match set up (so you should contribute at least that amount!)
- The investments available in the account are determined by your employer
