What is a 401(k)? A Beginner’s Guide
[Image of a person at work reviewing their 401k plan]A 401(k) plan is a retirement savings plan sponsored by an employer. It lets workers save and invest a piece of their paycheck before taxes are taken out. This is one of the most common and powerful tools for building retirement wealth in the United States.
Key Features of a 401(k)
- Employer-Sponsored: You can only participate in a 401(k) if your employer offers one.
- Payroll Deductions: Contributions are automatically deducted from your paycheck, making saving consistent and easy.
- Tax Advantages: 401(k)s offer significant tax benefits, which vary depending on whether it’s a Traditional or Roth 401(k).
- Investment Options: The money you contribute is invested in a limited list of funds (usually mutual funds) chosen by your employer.
- Contribution Limits: The IRS sets annual limits on how much you can contribute, which are much higher than IRA limits.
The Magic of the Employer Match
Many employers offer a “401(k) match” as an employee benefit. This means your employer will contribute money to your account alongside your own contributions, up to a certain percentage of your salary.
Example: A common match is “50% of contributions up to 6% of your salary.” If you earn $50,000 and contribute 6% ($3,000), your employer would add an extra $1,500 (50% of your $3,000). This is essentially a 50% return on your investment, guaranteed.
Rule #1: Always contribute at least enough to get the full employer match. It’s free money!
Traditional 401(k) vs. Roth 401(k)
Many plans now offer two types of 401(k) contributions:
- Traditional 401(k): Contributions are made *pre-tax*. This reduces your current taxable income, so you pay less tax *today*. Your investments grow tax-deferred, but your withdrawals in retirement are taxed as ordinary income.
- Roth 401(k): Contributions are made *after-tax*. You don’t get a tax break today. However, your investments grow tax-free, and qualified withdrawals in retirement are *completely tax-free*.
The choice depends on whether you expect to be in a higher tax bracket today (favoring Traditional) or in retirement (favoring Roth). Learn more about Roth vs. Traditional here.
What is Vesting?
Your own contributions are always 100% yours. However, the money your employer contributes (the match) may be subject to a “vesting schedule.” This means you must work for the company for a certain period (e.g., 3 years) before you fully own the matching funds. If you leave before you are fully vested, you may have to forfeit some or all of the employer’s contributions.
What Happens When You Leave Your Job?
When you leave your employer, you have options for your 401(k) account:
- Leave it with your old employer (if the balance is over a certain amount, usually $5,000).
- Roll it over into your new employer’s 401(k) plan.
- Roll it over into an IRA (Individual Retirement Arrangement). This is often called a Rollover IRA and gives you more investment choices.
- Cash it out (strongly discouraged! You will pay taxes *and* a 10% penalty if under age 59½).