What Is a 401(k)?

Saving for retirement can be daunting. After all, it’s so far away in the future; why worry about it now?

The truth is, planning for it early is exactly how you set yourself up for success. The sooner you start to save, the more time your money has to grow. And one of the easiest ways to kick it off is to begin contributing to a 401(k), a type of investment account specifically designed to help people save for their golden years.

But just what is a 401(k), how does it work and why is it so popular? Here’s what you need to know about one of the most common types of retirement accounts.

Whenever you start a new job, check to see if it’s included in your benefits package.

1. A 401(k) IS SPONSORED BY YOUR EMPLOYER

   That means you can only contribute to a 401(k) if your work offers a plan. So whenever you start a new job, check to see if it’s included in your benefits package. If it is, be sure to sign up and establish how much you want to contribute from each paycheck.

   Each employee is also responsible for choosing the investments within their 401(k) from the options provided by the 401(k) plan provider, although there is likely to be a default asset allocation set up initially. The investments you choose should depend on your risk tolerance, timeline to retirement and overall investing goals.

2. YOUR CONTRIBUTIONS ARE TAKEN OUT AUTOMATICALLY

   This is part of the reason why people like 401(k) plans — they make it easy to save. You can typically choose to contribute either a set percentage or a set dollar figure from each paycheck into your 401(k) account. Some plans also allow you to automatically increase your contribution periodically, like every six months or every year, making it even easier to increase your contributions over time.

   There are limits to how much you can contribute each year, however. In 2018 the IRS set the limit at $18,500 per year, or up to $24,500 for individuals 50 or older.

3. YOUR COMPANY MIGHT OFFER A MATCH

   As an added benefit, some employers offer to match some of the dollars you put into your 401(k) account, although with some parameters around how to become eligible for the match.

   For example, your company might match 50 percent of what you contribute up to 6 percent of your income. That means if you make $50,000 a year and contribute $3,000 to your 401(k) account (6 percent of your salary), your company will kick in another $1,500 on your behalf. It’s like free money for your retirement fund!

   While how much you choose to contribute to your 401(k) will be specific to your situation, it’s a good idea to contribute at least what your employer does — that way you’re maximizing the value of the match.

4. THERE ARE TWO TYPES OF 401(K)S: TRADITIONAL AND ROTH

   The primary difference lies in when you pay taxes on the money in your account.

   Traditional 401(k) contributions are made pre-tax, which means the amount you contribute helps lower your taxable income now. Your contributions also grow tax-deferred, meaning that you won’t pay taxes on them until you withdraw that money ideally when you retire. Remember: Withdrawing before age 59½ incurs big tax penalties. 

   A Roth 401(k), meanwhile, uses after-tax dollars. That means you don’t get a tax break on your contributions now, but you won’t have to pay taxes on your investment growth when you make withdrawals in retirement later (again, assuming you abide by the 59½ age rule). Roth 401(k)s, however, tend to be less common than traditional 401(k)s. But if your company does offer both, it’s possible you may be allowed to split your contributions between the two.

No investment strategy can guarantee a profit or protect against loss. All investing carries some risk, including loss of principal invested.