Saturday, 19 October 2019

What is a 401k?

What is a 401(k)?

One of the most common ways people save for retirement is by contributing to a 401k, a retirement savings account offered by many employers. So what is a 401k and does it work?

We will look at three main concepts:

  1. Contributions
  2. Investment
  3. Account Management

1. Contributions

  • Roth 401k
  • 401k Tax Benefits Have Some Limits.
  • Companies Offer a Match

But first let's start with the absolute basics: the name.

It's called a 401k because of the sections of the IRS code that sets out the rules for this type of account, sections 401 subsection k.

Basically, the government allows companies to offer retirement savings account with certain tax advantage in an effort to encourage people to save for retirement. Tax advantages are one of the main benefits of contributing to a 401k.

Read: What Is a Roth IRA Account and How Does It Work?

When you sign up for a 401k, you will set an amount or percentage to be automatically taken out of each paycheck to fund the account. With a traditional 401k, the amount you contribute is deducted from your taxable income.

Let's say you earn $100,000 per year and contribute $10,000 to your 401k. That means your total taxable income for the year would be $90,000, reducing the amount you have to pay taxes on that year.

In addition, the money you contribute to a 401k can grow tax-deferred, meaning you don't pay taxes on it until you withdraw it in retirement. In the meantime, the money in the account can compound without being taxed.

Roth 401k

Some employers also offer a Roth 401k, which allows you to contribute after-tax dollars. Instead of decreasing your tax burden now, this allows you to take the money out tax-free during retirement.

Only you can determine which 401k is right for you. It depends on several factors, like how much you expect to earn later in life and whether you want tax benefits now or later. Some people choose to contribute to both. Talk to a tax professional for more information.

401k Tax Benefits Have Some Limits.

The money you put in a 401k is basically untouchable until you turn 59½. If you withdraw money before then, you will face an early withdraw penalty and income tax, unless you qualify for one of the few exceptions, like paying for substantial medical expenses or disability.

Overall, it's best to avoid jeopardising your retirement savings with early withdraws. 

The IRS limits how much you can contribute to a 401k each year. These limits have changed over the years and can depend on your age, so it's best to check with the IRS or a tax professional. 

Companies Offer a Match

Another major benefit of participating in a 401k is that some companies offer a match. That is extra money the company contributes to your account just for participating, and it doesn't count toward your individual limit.

Say your employer matches 50% of all your contributions up to 6% of your annual salary. This means if you make $50,000 and contribute 6%, that is $3,000, your employer would contribute $1,500 on top of that.

If your employer offers a match, be sure to contribute enough to get the maximum amount. Don't leave free money on the table.

Keep in mind, some companies have what is called a vesting period. That is the period of time you have to work there before the money the company contributes to becomes fully yours.

Check with your employer to learn more about your company's policy.

Now that you understand contributions, let's talk about choosing investments. 

2. Investment

  • Self-Directed 401k

401k typically offers a limited number of investments, like mutual funds or exchange-traded funds. If you find the number of investment choices too limited, see if your employer offers self-directed 401k.

Self-Directed 401k

  • Growth Fund
  • Stocks
  • Options
  • Futures

These plans may provide additional investment choices. Either way, you will have to weigh the risk and fees associated with each investment. It's generally best to not take the money out until you reach retirement age, so focusing on long-term investing rather than quick profits might be a prudent choice.

3. Account Management

  • Fees. 
  • The Rollover
  • 401k

When managing your account, be on the lookout for the drawback of 401k:


Some 401k providers charge additional administrative fees on top of the cost of individual investments. 

  • 401k Provider
  • Investment Fee
  • Administrative Fee
  • Industrial Service Fee

These fees are not always obvious, so check with your plan administrator or use an online 401k fee analyser. If you are unhappy with the fees you are paying, you can consider other retirements like Individual Retirement Account or IRAs

Even if your 401k offers limited investment choice or charge high fees, it may still be worth contributing enough to get the maximum match from your employer. The match may outweigh these drawbacks. 

The Rollover

Over time, you will likely work for several companies, which could mean you have many 401ks. So what do you do with those old accounts? You can always combine them into your current 401k or an IRA through a process called a rollover.

This allows you to move funds directly from one retirement account to another without incurring tax penalties.

  • 401k
  • Traditional IRA
  • HSA
  • 403b
  • Roth IRA Taxable Account

Keeping your retirement savings in fewer accounts make them simpler to manage. The 401k is just one kind of retirement account, but the tax benefits and potential employer match make it a powerful way to invest in the future. 

Contributing to a 401k is one of the simplest ways to pay yourself first. 

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