401k Explained

When I started my career after graduating college, I had heard of the terms 401k, IRA, Roth IRA, pension, etc but had no idea how they worked or what exactly all those acronyms stood for. With this post I’m hoping to explain and clear up any confusion around one type of account: the 401k. The 401k is named for the subsection of the Internal Revenue Code that it was written in, very creative right? A 401k is a retirement savings plan that is offered by employers to their employees. While an IRA (individual retirement account) is set up by the person, this is an account that will have to be opened through your employer. Around 80% of all full-time workers in the United States have access to a 401k plan, so it’s important to understand how to use this account to save money towards your retirement.

The main benefit of placing your money in a 401k is the fact that contributions to this account are tax deferred. The contributed money is tax deferred and the earnings are not taxed as long as they are in the account.  You are not able to withdraw from your 401k without penalty until you reach the age 59 ½ , although there are a few ways around this. Some employers may offer one time loans against your 401k for a down payment on a house, and many also offer the same option for specific severe hardships. I strongly recommend against ever taking a loan out against your 401k as you are eliminating the very benefits that it offers! There is also the ‘72t’ rule which allows you start taking payments from your 401k earlier than retirement age, but certain conditions must be met and it’s much more complex issue. I will save that information for its own post.

Once you hit the age of 59 ½, you can withdraw the money while only paying regular income taxes on your withdrawals– no penalties added. You do have to begin taking out money before you turn 70 ½ though, as a similar penalty is assessed for leaving the money in the account for too long. This is meant as a retirement vehicle, not something to pass wealth onto the next generation.

The other nice thing about 401k is that they have a much larger yearly contribution limit compared to IRAs. As of 2016 you are able to contribute up to $18,000 of your own money into the account. Many employer’s also offer a “match” that can give you even more money. You might be contributing 3% of your paycheck into your 401k and as an incentive your employer may also kick in another 3% into the account.  There is also a limit of $51,000 on total contributions to the account, which includes employee and employer contributions.

Finding a company that offers a great 401k match rate is essentially like receiving a raise on top of your normal salary. Your employer is setting up the account, so they are the ones selecting the investments. Most companies have a good variety of low-cost funds to invest in, but some employers do make poor decisions.

If you employer options are truly terrible with extremely high fees and no employer match, I recommend investing your money into a traditional IRA before investing into your 401k. You can choose your own options and save money that way. Once you max out your traditional IRA, it may be worth it to invest into your 401k for the tax benefits. You may also try speaking with your HR department to see if you could have them look into other options.

Many companies also have a “vesting” schedule on their 401ks, which means the money is not actually yours until you stay with the company for a certain amount of time. If your employer makes you wait 3 years until you are fully vested, and you only planned on staying with the company for 2 years at most this will not be a good investment. In this situation, it’s probably better to invest your money elsewhere before using your 401k.

I think that the three most important things to remember about your 401k are:

  1. Start investing into your 401k right away. It might seem like you are receiving less money in each paycheck, but this is easier to adjust to right away instead of a few months down the line! Plus the longer the money is in the account, the more time it will have to grow.
  2. Take advantage of your employer match at all costs. This is free money! If your employer matches up to 6% of your contribution, try to contribute at least 6% of your own pay into your 401k.
  3. Try to select the options that are low fee. Some 401ks will offer very expensive funds for you to invest your money in. Try to stick with funds that have the lowest fees so that you are putting more money in your own pocket, not the person managing the fund.

Image Source: Zachary Staines @ Unsplash

2 thoughts on “401k Explained

  1. I love 401ks. A tax attorney told me that if I had no income the year before I take out my 401k, I would pay no taxes. I’m going to take this with a grain of salt and hope that it’s true 38 years down the road!

    • Yeah they are a great tool to save money with! I’m not sure about the statement about no taxes, but it seems true if you are under the income threshold? If you are taking out larger sums I can’t see away around paying taxes, but I am not an expert.

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