Let’s talk about the 401k. With a name like that, no wonder so many people don't know what is a 401k.
This guide will explain exactly what a 401k is, why they matter, and why should be taking advantage of one. Chances are you will learn more than you ever wanted to know about 401ks.
We'll admit it, with no one to teach us about money and personal finance at home growing up, we waited too long to take advantage of the 401k.
In fact, when Camilo started his first job after college as an investment banker at J.P. Morgan in NYC, he didn't sign up for the company 401k right away.
Having studied finance at the Wharton School of Business, he understood the importance of saving and investing, but he didn't fully understand what a 401k was.
In fact, he thought he was making the smarter move by not contributing to the 401k.
You see, after reading the fine print, he realized that he wasn't eligible for the company match until he completed 1 year of service. The company match is where your employer matches your 401k contributions (“free” money).
His plan was to wait until his 1-year anniversary to sign up. In the interim, he invested some of his extra income in a taxable investment account.
That sounds reasonable, right? So what's wrong with what he did?
Not utilizing a 401k can be a costly mistake!
The problem was that at the time, he didn't realize that a 401k also had other benefits besides the match! One of those other perks is that 401ks have tax advantages.
So he ended up paying more money in taxes by not taking advantage of his account. A lesson we had to learn the hard way. Thankfully, we wrote this article so that you don't make the same mistake he did.
After reading this post you'll know what a 401k is and how they work.
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 a plan you put money into and then must invest so that you have money when you retire.
Employer sponsored means that the company you work for organizes the plan and helps to administer it.
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.
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! If your company matches your contributions, there will almost always be a cap on the amount that they will match.
The fact that your contributions are made directly from your pay is usually under-appreciated. As you know, 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.
401K 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 [IRS]:
- 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.
Thanks for reading! You should now be able to answer the question of ‘what is a 401k?' the next time someone asks you!
Camilo is a personal finance expert who was raised in poverty by a single mother and had to learn everything about personal finance on his own. In addition to running The Finance Twins with his twin brother, he has been featured on Forbes, Business Insider, CNBC, US News, The Simple Dollar and other top publications. Camilo began his career as an investment banking analyst on Wall Street at J.P. Morgan. He has a master of business administration (M.B.A.) degree from Harvard University and a Bachelor of Science in finance from the Wharton School of Business at the University of Pennsylvania. You can contact Camilo here or via Instagram @thefinancetwins.