What is a 401(k)

What is a 401(k) – Save for Retirement Paycheck to Paycheck

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401(k) plans are employer sponsored plans that provide their employees with the opportunity to save for retirement.  If you contribute to a plan your contributions are generally tax deferred until you decide to withdraw the funds – typically at the time of retirement.

Your 401(k) plan is a retirement plan that is qualified by the Internal Revenue Service Tax codes, i.e. the IRS gives you tax breaks if you participate to save for your retirement.

There are a number of different types of 401(k) plans, however here are the key points you should consider.

  • Your 401(k) should always be considered a long-term retirement vehicle, there are penalties for early withdrawal. Currently the minimum age for withdrawal is 59 ½.
  • In some cases the employer offering the 401(k) option provides some sort of a matching contribution. For example: if you put a $100 into your 401(k) your employer will also provide a $100 match into your plan.

 

What is a 401(k)?

 

  • Traditional 401(k)s allow you to contribute to the plan as a percent of your salary – 1%, 3%, 5%…and so on.
  • A 401(k) provides pre-tax benefits. In 2016 the maximum contribution you can contribute to a 401(k) is $18,000 (annually), excluding employer contributions. Pre-tax means the amount you contribute to your 401(k) lowers your taxable income – this allows you take home more money.
  • Consider your 401(k) as a non-liquid investment. Don’t plan on withdrawing from the plan unless you want to face stiff penalties.
  • Traditional 401(k)s are taxed when you begin to withdraw funds.
  • Some employers have a vesting schedule. A vesting schedule may require you to stay employed with the company a certain period of time before you actually own their contribution (match) portion of the 401(k)
  • 401(k) plans provide numerous long-term investment options. Stocks, mutual funds, bonds or a combination of all three may be available for you to invest in.  Some companies will even allow you to invest in their stock as an incentive for employees to re-invest back into the company you work for.  You make money from your 401(k) based on the rate of return of the vehicles you invest in – the stocks, bonds, and target date mutual funds.
  • Risk – Your 401(k) should be considered a medium risk level. The reason for this is the investments you subscribe to under the plan can fluctuate based on the stock market’s performance.  If the stock market performs poorly your 401(k) return may suffer and may force you to hold off on withdrawals (if you are close to retirement) until the market recovers.

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Where available, 401(k) plans are a popular retirement vehicle for many employees.  Matching contributions is one of the primary reasons.  If your company will match a percentage of your income each time you contribute then you should take advantage of this opportunity to double your money.  Think of matching contributions like this.  What if each time you gave someone $10 they turnaround and gave you $20 back – you would probably jump on that opportunity each time, right?  That’s what a matching contribution is.  Your doubling your money each time you contribute.

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Do you contribute to a 401(k)? Why? Comment below.

 

 

Kevin is the owner of FTP and an author of the personal finance book series Filling The Pig. He uses his own past successes with debt, saving cash, investing and running his own home based businesses to teach others about Creating a Lifestyle of Opportunities.

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