401k Basics

A 401k is a company or employer sponsored retirement plan that allows workers to deduct a portion of money from their pay check, and have the money transferred into a retirement plan account where the money earns interest tax-deferred. Tax-deferred means this saved income is not taxable until you withdraw it at the age of 65 or more. You decide how much money you want deducted from your paycheck and deposited to the plan based on limits imposed by plan provisions and IRS rules. Your employer may also choose to make contributions to the plan, but this is optional. A 401k is a retirement plan, not a savings account. Money placed in a 401k is not easy to access in an emergency. Some plans allow loans and hardship withdrawals, but the rules governing them are restrictive.

Don't put off participating in your 401k, even if you think you can't afford to. Time is your best guarantee that you will make your retirement goals, so the sooner you start contributing the better off you are going to be in retirement. Even just one or two percent will make a big difference. It is your responsibility to decide if you want to participate in the 401k, and if so, how much you will contribute each pay period. If you earn $750 each pay period and elect to defer 5% of your pay, $37.50 is taken out of your pay and placed in the 401k plan. These contributions are deducted from your salary on a pre-tax basis. This means that by contributing to a 401k, you actually lower the amount you pay in current income taxes. For example, instead of being taxed on the full $750 per pay period, you are only taxed on $712.50 ($750 minus your 401k contribution of $37.50 equals $712.50). You don't owe income taxes on the money contributed until you withdraw it from the plan.

It is your employers responsibility to administer the plan in accordance with laws and regulations, they will also determine who is eligible for the plan, how much they can contribute, whether those contributions will be matched and so on. Because of this the 401k is a very easy way to begin preparing for retirement, it really requires very little effort on your behalf.

Many employers contribute to your 401k by matching some or all of your contribution. That means you could put in 3% of your pay, and your employer agrees match that 3% for a total of 6% of your wages going into the 401K. Stop and think about this for a second. You have $5000 and put it into your 401K account, your employer matches your $5K and now you have $10K in your account. This is a 100% instant gain for you! By participating in your company sponsored 401K you turned $5000 of retirement income into $10K instantly, with no risk, no work, nothing. That is something you just can't turn down, and is probably the most important reason to put money into your company sponsored 401K at least up to the point that they offer to match it.

By investing in your 401K retirement fund you you have a reduced income tax bill the year that you do it, since any money you contribute is not counted as income that year. This effectively reduces your income, and your income tax due, so more money stays in your pocket and not in Uncle Sam's. Another plus for investing in your 401K fund is the money in your 401K account is allowed to grow tax-free as long as it is in there, letting it compound and grow faster. You don't pay taxes on the money when you earn it, you pay deferred taxes on the money when you eventually retire and take it out and begin spending it. Hopefully when you retire and your regular income drops significantly, you will find yourself in a lower tax bracket when it comes time to pay taxes on this deferred income - maybe 25% instead of 40%.

When investing in your company sponsored 401K program, employees should do their homework and be proactive with their savings. Important questions to ask your employer about your 401K account include: How much will the company match on my contributions? What is the vesting schedule on the company matched funds? Can I choose how the money is invested? Is it possible to get a loan on my 401k earnings?