What is a 401(k)?

October 15, 2014 : H&R Block

What’s a 401(k), you ask? At its core, a 401(k) an investment tool for retirement. It is a type of plan called a “defined contribution plan.”

You put money into an account that is then invested in stocks, bonds, money market accounts and more. You work with a company – like Fidelity Investments or Vanguard – to select the mix of investments. This amount of money grows over time, and typically provides a better return than a traditional savings account. Once you retire, you can begin to withdraw funds from the 401(k) to support yourself.

What makes it unique?

  1. 401(k) plans are offered – or “sponsored” – by employers. You can’t just go open one up on your own.
  2. Money invested in a 401(k) is deducted from your paycheck before taxes. However, it will be taxed when you withdraw money during retirement. The idea is that your tax rate in retirement will be lower than your current tax rate.
  3. Employers will often match a certain percentage of the amount you put into the plan (also called your “elective deferral”). Let’s say you send 4% of your salary to your 401(k). It’s possible that your employer may contribute additional money to this retirement account. It could be 1%, 2%, 3% or more. However, employers aren’t required to make this contribution, so the amount will vary widely. People often refer to this as “free money!”

What’s the catch?

There aren’t too many, but there are a few additional things to know about.

  1. As of 2014, the maximum you can defer into your 401(k) is $17,500 per year unless you are age 50 or over. In that case, you can defer up to $23,000.
  2. If you take money out of the account before you are 59.5 years old, you will typically incur a 10% penalty in addition to the regular income taxes you must pay.  So a 401(k) should definitely be considered a long-term savings strategy.
  3. The growth will depend on the market at large. Over time, the stock market shows very consistent growth, so this isn’t a risky strategy. However, there is no guaranteed return. You may grow your savings 2% or 12% in a given year. Just remember that, generally, over time these retirement accounts deliver better returns than a savings account.

My employer doesn’t offer a 401(k) plan.

There are many other defined contribution plans that are similar to a 401(k).

Employees at tax-exempt institutions may be able to participate in a 403(b) plan. Government employees could have a 457 plan, and federal civilian employees might have a Thrift Savings Plan. Your employer might offer a Roth 401(k), which is similar. The key difference is that with a Roth 401(k) plan income tax is paid at the time of investment, not when funds are withdrawn during retirement. The taxation of any distribution will depend on whether or not it is “qualified.” In most cases, a participant must wait until at least age 59.5 before he or she can receive a qualified Roth 401(k) plan distribution.

If your employer doesn’t offer any of these plans – or if you are self-employed – you can start an individual retirement account (IRA), MyRA, Roth IRA or SEP IRA.

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