You’re probably here because you’re wondering what a 401k is. In the most basic sense, a 401k is simply a retirement plan, but there are a few details you should know.
This guide will explain exactly what a 401k is, why they matter, and why should be taking advantage of one. You’ll probably you will learn more than you ever wanted to know about 401ks, but that’s a good thing.
If you aren’t contributing to a 401k yet, don’t beat yourself up. The important thing is that you start as soon as possible though.
If you aren’t contributing to a 401k you aren’t alone.
I’ll admit it, with no one to teach me about money and personal finance at home growing up, I waited too long to take advantage of the 401k.
In fact, when I started my first job after college as an investment banker at J.P. Morgan in NYC, I didn’t sign up for the company 401k right away.
I, foolishly, thought I was making the smarter move by not contributing to my 401k.
Having studied finance at the Wharton, I knew how important it was to save and invest. But I didn’t fully understand how 401ks worked.
There’s benefits, even if you don’t get a company match.
My first company didn’t make matching contributions until your 2nd year of working. The company match is where your employer matches your 401k contributions (“free” money).
My plan was to wait until my 1-year anniversary to sign up. In the interim, I invested some of my extra income in a taxable investment account.
That sounds reasonable, right? So what’s wrong with what I did?
Not utilizing a 401k can be a costly mistake!
The problem was that at the time, I didn’t realize that a 401k also had other benefits besides the match! One of those other perks is that 401ks save you money on taxes.
That means I ended up paying more money in taxes by not taking advantage of the 401k. A lesson I had to learn the hard way.
Thankfully, you’re reading this article now and won’t make the same mistake!
This post will explain exactly what a 401k is and how they work.
Exactly What Is A 401K?
A 401k is an employer-sponsored tax-favored retirement account that you contribute pre-tax wages into. At its most basic level, a 401k is simply an account at a financial institution that you use to save and invest for retirement.
A 401k is not an investment itself, and it’s not a pension. A 401k is an account you put money into. You must then must invest the money in the account so that it grows for when you retire.
Employer sponsored means that the company you work for organizes the plan and helps to administer it. Some employers will put money in your account for you, while others won’t.
The Tax Benefits Of 401Ks
To keep it simple, tax-favored basically means that the government will allow you to pay less taxes if you invest using this plan compared to making the same investments outside of a tax-favored account.
The way this works are that your 401k contributions are tax deductible. This means that money is not taxed when you put in your 401k.
You will end up paying tax when you finally take the money out, but it’ll be less than if you initially paid income tax, invested it, and then paid capital gains tax.
How Do 401k Contributions Work?
Your contributions are typically taken directly out of your paycheck via payroll deductions prior to tax withholding.
This benefit cannot be overstated. Research has shown that by making the contributions directly from your payroll, you are more likely to invest. And also invest larger sums. It’s a game-changer.
One of the best features of 401ks is that employers can contribute money in addition to the money you put in! Some employers will match the amount that you put in, which increases the amount of money going into the account each time!
Yes, you read that correctly.
The company you work for may offer to match the amount you put in, and it will not cost you a dime (besides your time working there…)! If your company matches your contributions, there will almost always be a cap on the amount that they will match.
As I mentioned earlier, the fact that your contributions are made directly from your pay is huge! Sticking to a budget isn’t always easy. Which means that it’s way too easy to spend more money during a month than you meant to.
But that problem doesn’t really exist if you never had the money in your checking account in the first place.
The behavioral impact of having the 401K contributions coming directly from your paycheck is HUGE.
401Ks Have Annual Contribution Limits
As you’re probably starting to realize, the 401k is a pretty awesome way to save for retirement. But the tax savings are so awesome, that the government puts a limit on how much money you can put in a 401k.
In 2019, the limit you can contribute to a 401k is $19,000, which would be hard to reach for most young professionals. Unlike Roth IRAs, there is no income limit to contribute to a 401k.
The one exception to the contribution limit is that once you turn 50, you can make catch-up contributions if you did not max it out in prior years. But the rules may change by the time we turn 50.
The 401k annual contributions are also sometimes called elective deferrals, since you are deferring your money until later in life, so just keep an eye out for that when you are signing up for your 401k at work!
How Does Taking Money Out Of A 401K Work?
There are rules on how and when the money can be taken out of your 401k.
Per the IRS, distributions from 401ks cannot be made until one of the following occurs in order to avoid a penalty:
- “You die, become disabled, or otherwise have a severance from employment.” (This includes retirement from your job.)
- “The plan terminates and no successor defined contribution plan is established or maintained by the employer.”
- “You reach age 59½ or incur a financial hardship.”
- If you reach age 70½ and have not retired, you are required to take distributions.
Once one of the above criteria are met, the distributions (payments to you) are either done periodically (scheduled) or non-periodic (e.g. one lump sum per year) depending on the terms of your particular 401k. The distribution amount is determined by a plan administrator and takes several factors into account such as your life-expectancy. See the IRS’s Publication 575 for details.
Early Withdrawals From A 401K
Early Withdrawal takes place when you take funds from your 401k before age 59 ½. Typically there is a 10% early withdrawal penalty on early withdrawals, on top of income taxes.
401k Early Withdrawal Exceptions:
The 10% tax will not apply if distributions before age 59 ½ are made in any of the following circumstances:
- Made to a beneficiary (or to the estate of the participant) on or after the death of the participant,
- If made because the participant has a qualifying disability,
- Made to a participant after separation from service if the separation occurred during or after the calendar year in which the participant reached age 55
These are only some of the exceptions, so make sure to check the full list before taking an early withdrawal.
What if my company doesn’t offer a 401k?
If you work for a non-profit organization such as schools, universities, churches, charities and hospitals that are 501(c)(3) organizations, they may offer a 403(b) plan.
This is their equivalent of a 401k. They may offer a match, much like a 401k. A company may have one or the other, but cannot offer both a 401k and 403(b) to their employees.
If you are not sure what your company does and does not offer, ask your HR (human resources) department!
Do not worry if your company doesn’t offer a 401k retirement plan! Many employers don’t.
If your employer doesn’t offer any retirement plan like a 401k or a 403b you will have to save for your retirement in a different type of account.
The IRA (Individual Retirement Arrangement) was created specifically for people to save for retirement on their own. There are contribution limits and other factors to take into account, but you can learn everything in our IRA guide here!
Frequently Asked Questions
Should you participate in your company’s 401K plan instead of investing in your own IRA or taxable investment account?
Short answer: YES, but ideally you’ll do both!
Long answer: It’s your hard-earned money and you definitely have choices! You can opt out of your employers 401k or 403(b) and max out your IRA or invest in something else.
Here at The Finance Twins, we think you should definitely take advantage of your company’s 401k or 403(b) first, especially if they will match you!
That is free money they are throwing on the table and walking away from that is like walking past a $20 bill on the ground! What we’d do is contribute enough to earn the full employer match and then work on maximizing our IRAs (see our post on IRAs!).
How Should I Invest The Money In My 401K?
If you opted into your work’s 401K you are probably wondering what to do next.
Fortunately we have a lot of guides on learning how to invest. Personally, we have the vast majority of our retirement savings in low cost index funds.
Thanks for reading! You should now be able to answer the question of ‘what is a 401k?’.
Camilo is a personal finance expert and the Co-Founder and CEO of The Finance Twins. I was raised in poverty by a single mother and had to learn everything about personal finance on my own. I have been featured on Forbes, Business Insider, CNBC, and US News. Earlier in my career, I worked as an investment banking analyst on Wall Street at JPMorgan Chase & Co., and I have an M.B.A. from Harvard University and a B.S.E. in finance from the Wharton School of the University of Pennsylvania.