What Is a 401k? Everything You Need to Know

Do you have the option of setting up a 401k plan? Does your employer offer a 401k matching benefit? Are you confused about what these words even mean? Don't worry! We'll explain everything you need to know about these accounts, but, first, what is a 401k, exactly?

A 401k is a retirement savings account sponsored by an employer and designed by the government to give you tax benefits on your savings. Your money quietly grows until the time you can withdraw it in your late 50s.

This guide will explain exactly what a 401k does, what you can and can't do with it, how to put money in it, and how it can set you up for a financially secure retirement. For anyone new to the world of 401k plans, let’s start with a quick review of terms.

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Saving for Retirement Terms: A Glossary

Here are some terms you’ll see throughout the guide and a brief working definition of each:

While Roth 401k’s are gaining in popularity, most of us will still be offered a traditional 401k through our company. Therefore, we'll start by going more into detail about traditional accounts to answer our million dollar question: what is a 401k plan?

What Is a 401k?

A 401k is an employer-sponsored retirement savings account. Not all employers offer 401ks, but those who do determine how it works. For instance, the employer chooses the various funds that make up your 401k portfolio. Since your employer has to offer it, you can't set up a solo 401k on your own.

If you decide to open a 401k account, you’ll typically contribute money to it automatically each month or year. If so inclined, your company may match your contributions anywhere from 25% to 100% (some companies even go beyond 100% for the highest paid employees). Some 401k companies start by matching a small percentage of your contribution and increase this percentage the longer you work for them.

There are lots of ways you can save money for retirement, including establishing an IRA or brokerage account or collecting bills in an old coffee jar. What are the advantages of putting money into a 401k as compared to these other methods?

What Are the Advantages of a 401k?

There are several advantages to a 401k, as well as a few limitations. Let’s start with the benefits.

#1: Tax Benefits

401k plans allow your money to grow untaxed. Traditional 401ks let you contribute pre-taxed money. When you eventually withdraw the money, that’s when you’ll pay taxes on it.

Roth 401k plans have you contribute already taxed money. When you take it out, you don’t have to pay any taxes on it.

IRA and Roth IRA accounts also have tax advantages, but they often set restrictive limits on how much money you can contribute per year. Some only allow you to put in $5,500 a year, while 401k plans, as you'll read below, allow you to put up to $18,000, or even more if you're including an employer match.

In a brokerage account that you can set up independently of an employer, your money would be taxed twice. In a 401k (traditional or Roth), your money is only ever taxed once. This tax set-up is a big benefit of 401k accounts.

#2: Annual Compound Growth

The second advantage of putting your money into a 401k as opposed to say, a coffee jar, is that it allows your money to grow over time. Thanks to the power of compounding interest, you could see your money grow significantly over decades.

If you contribute $5,000 per year when you’re 25 and your money grows at a 5% annual rate, for example, then you would have an additional $30,000 more than you would if you started contributing ten years later. You’ll see significantly more money the earlier you start saving.

#3: Employer Matching

Some, but not all, employers will match a percentage of your annual contributions. Employer match is essentially free money! Unless you really can’t afford it, you should strive to get the full employer match you can per year to make the most of this offer.

#4: High Contribution Limits

As mentioned above, 401k plans also have higher contribution limits than some independent retirement accounts. Some IRAs only let you put about $5,500 a year, while 401k limits are set at about $18,000, depending on the year.

That limit doesn’t include any matching contributions made by your employer, so you could actually put a lot more per year into your 401k. We’ll get into the exact numbers below.

All in all, 401ks are appealing because they offer significant tax advantages for your retirement savings, allow your money to grow over time, and they may involve significant contributions from your employer.

That being said, there are some 401k limits that you should know about. Below are the three main limitations.

What Are the Limitations of a 401k?

Since your company offers the 401k plan, it also sets up certain rules and regulations. For instance, your employer chooses the stock options that make up the 401k.

While you might have unlimited options with a brokerage account, you may only have a few with your 401k. This can actually be an advantage for some people, who would rather take a more hands-off approach to how their money gets invested.

Secondly, some employers put in place a “forfeit law.” If you get laid off and have less than a certain amount of money in your 401k, then you don’t get that money back. Your company will set this amount and the details of any forfeit law. Make sure to ask whether or not your company has one.

Finally, some companies also require you to work with them for a minimum number of years before you’re fully “vested” and can retain their matching contributions. If you leave or lose your job before that time, you can still keep your own savings, but any employer match contributions will disappear.

Now that you know the advantages and limitations of a 401k, what do you have to do to set one up? Do you choose your investments, or does the company decide for you?

What Steps Should You Take to Set Up Your 401k Plan?

The first step in establishing your 401k plan is signing up with your employer. Typically, your employer or an HR professional should go over the steps with you when you get hired. If you chose not to sign up when you first started working at the company, you can still speak to your employer about how to sign up now.

As you fill out the requisite paperwork, you’ll decide how much money you want to contribute. You can increase or decrease this amount if your circumstances change, but you won’t be able to withdraw money once you’ve deposited it (before retirement age) without a penalty.

Once you’ve opened your account, you can take an active investing approach or put the 401k on autopilot. As mentioned above, your employer will choose the stock options, and you can choose how your money gets distributed among them. The majority of people, though, simply go with a “target-date” fund.

With a target-date fund, you set the date you might retire, say, 2050, and the 401k does the rest. You won’t have to design your portfolio; instead, the account itself will adjust how your assets are allocated over time.

If you do decide to take a more active approach, a good rule of thumb to follow is to have a diversified portfolio that can ride out the ups and downs in the market. With a diversified portfolio, you can help make sure that your savings will grow over time.

While the amount of money you can afford to contribute to your 401k varies by individual, there are certain limits in place. Read on for the 401k contribution limits in 2016.

How Much Money Can You Contribute to Your 401k?

There are 401 k limits that determine how much money you can contribute to your account per year. These 401k contribution limits fluctuate a bit over time along with inflation.

As of 2016, people under 50 could put in up to $18,000 per year. People over 50 could put in $24,000. The additional $6,000 is considered a “catch up” contribution for those who didn’t max out their limits in earlier years.

Any company matching doesn’t count toward this 401k limit. The maximum combined contribution (yours plus your company match) can go up to $53,000.

A good rule of thumb is to invest about 10% of your annual income, if possible. If you have employer matching, then you should also strive to get the biggest match contributions you can.

Besides 401k limits, there are also rules about when you can take money out of your 401k. Read on to learn when you can make a 401k withdrawal.

When Can You Get Your Money Out of a 401k?

You can take money out of your traditional 401k starting when you’re 59 1/2 (regardless of whether you've retired or not) OR if you retire at age 55 or higher. If you try 401k withdrawal before that time, then you’ll incur a hefty 10% penalty fee.

So far, everything discussed applies mainly to traditional 401k accounts. They let you contribute pre-taxed money and have penalties for withdrawing money before you reach a certain age.

There is one other kind of 401k with different rules and regulations called a Roth 401k. Read on to learn more about a Roth 401k and how it differs from the traditional 401k accounts that most employers offer.

What Is a Roth 401k?

In addition to a traditional 401k, some companies also offer a Roth 401k. A Roth 401k has a few differences from a traditional 401k.

The most important difference is that a Roth 401k has you contribute money after it’s been taxed. When you withdraw money from the account later, you won’t have to pay taxes on it.

The second difference has to do with 401k withdrawal rules. A Roth 401k plan lets you take out your money at any time without penalty after you’ve held the account for five years. You won’t have to pay a 10% penalty as you would on a traditional plan for Roth 401k withdrawal before a certain age or retirement.

If your employer offers both traditional and Roth 401k options, which one should you choose?

Traditional 401k vs. Roth 401k: Which One’s Better?

If your employer offers both a traditional 401 k and a Roth 401k, then you have to decide which one to choose or, alternatively, whether to set up both types. Essentially, you want to figure out which type of 401k will help you save the largest amount of money in the long run. There are also some psychological factors that come into play.

#1: Do You Want to Be Taxed Now or Later?

As you read above, a traditional 401k taxes your money later while a Roth 401k taxes your money now. If you’re young, not making a lot of money, and not currently getting taxed highly, then a Roth 401k might be the preferable option. While you won’t be putting as much money into the account initially, you will be able to leave your money for many years to grow.

If you’re older, make a high paycheck, and are in a high tax bracket, then you might want to go with a traditional 401k. That way, your money will be taxed when you retire and are in presumably a lower tax bracket than you are presently.

#2: How Is Your Financial Self-Control?

Beside figuring out the tax situation, there’s a self-control factor to think about. If you need all the money in your traditional 401k, then you’ll want to set aside other savings to pay the eventual large tax bill.

Will you be able to set aside money to pay taxes later, or at least plan around the large chunk of your savings that will get taken away by taxes when you retire? On the flip side, if you open up a Roth 401k, will you have the self-control not to withdraw any of your savings after the five-year mark when you can withdraw penalty-free?

Besides weighing the tax benefits, you should ask yourself these questions to figure out which option is better. Finally, you might not decide not to choose between them at all and instead opt for both types of accounts.

Should You Choose Both a Traditional and Roth 401k?

Some financial advisors suggest going with both a traditional 401k and a Roth 401k if you have the option. You don’t actually have to choose one or the other, but instead, can split your savings between the two.

Going with both is similar to diversifying your stock portfolio to reduce risk. We can’t know what tax laws will come into play in the future, so choosing both a traditional and Roth 401k is a way to hedge your bets.

Now that you know the ins and outs of both traditional 401ks and Roth 401ks, let’s go over the essential points that you need to remember about saving for retirement.

What Is a 401k? Just the Essentials

These are the key points you need to remember about a 401 k plan:

• A 401k is a retirement savings account that some employers offer.
• You can contribute a certain amount per year, and your employee might match your contributions (free money!)
• In a traditional 401k, your money is taxed when you withdraw, not now.
• In a Roth 401k, your money is taxed now, not when you withdraw.
• 401k tax policies are superior to those of brokerage accounts, where your money is taxed twice.
• Your money will grow over time thanks to the power of compounding interest.
• Start early to have the most amount of money saved for retirement!

Now that you have a better understanding of what HR is talking about during new employee orientation, how should you proceed? Should you join in on the 401k fun?

Should You Contribute to a 401k?

Magic 8 ball says, “Most likely!” Unless you can’t cover your living needs, there’s no reason not to set aside some money for Future You. She’ll really appreciate it.

Of course, your employer has to offer a 401k plan. If your company doesn't offer 401k benefits, then you can't set up a solo 401k. You could instead save money for retirement in an IRA, Roth IRA, or brokerage account.

If you do have the option of a 401k, a good rule of thumb is to invest as much money as you can, perhaps about 10% of your income. If possible, try to max out any employer matching benefits so you get the most money you can from your employer toward your retirement savings. Start early to maximize the power of compounding growth.

401k accounts offer a simple, hands-off approach to saving for retirement. With just a little paperwork and rearranging of your daily expenses, you can save for retirement and reap huge financial benefits in your golden years.