What is a 401(k) Plan?

401(k) plans are employment benefits designed  for saving for retirement. For some people, a 401(k) is the only retirement asset they have. Unfortunately, most people never learn how these things work from the ground up. And whenever there’s confusion about how something works, people tend to get overwhelmed and do nothing until they feel more comfortable about what they’re dealing with.

A bit of knowledge can help you over the hump, and you don’t need to be an expert to get started – so let’s jump in with exactly what a 401(k) plan is.

In a nutshell, here’s what you need to know:

  • A 401(k) is a plan for retirement savings
  • You save some money, and your employer might add additional funds to your account
  • You may get some tax benefits from using the plan (sometimes you can benefit today, or you can choose to wait)
  • You invest the money and hope it grows
  • Your post-retirement “paycheck” comes from the money you accumulate in the plan

What is a 401(k) Plan?

A 401(k) is simply a retirement plan. The term “401(k)” doesn’t mean much to most people, because it’s a reference to the tax rules that allow companies to use these plans. So to simplify things: 401(k) is just a fancy way to say “retirement plan.” It is a tool that helps you save money for your future, and it is an especially powerful tool.

There are other types of retirement plans and retirement accounts out there, and 401(k)s are similar to those accounts in many ways. If you’ve ever used an IRA, SEP, SIMPLE, 403(b), 457, or even a Keogh, you probably already have a basic understanding of 401(k) plans.

Who Creates a 401(k) Plan?

401(k) plans are offered by employers. If an organization wants to use a 401(k) plan, they create the plan by signing legal documents. Technically these documents create a trust, which holds all of the assets in the 401(k) plan. This is important, because the trust dictates exactly how the money can be used – the company does not have any right to pull funds out for any other purpose (to pay business expenses when the company falls on hard times, for example). Almost any employer can create a 401(k) plan:

  • Nonprofit organizations
  • For-profit businesses
  • Self-employed individuals

Note that the money in a 401(k) plan is your money. Once you stop working for your current employer, you have the option to take that money out of the plan: you can roll it to a different retirement account, or you can cash it out and start spending the money (although taking a large distribution could lead to taxes and penalties, not to mention wiping out your retirement savings).

What Happens in a 401(k) Plan?

Employee contributions: Once a 401(k) plan is established, employees can contribute to the plan through payroll deduction. In other words, they save money by having a portion of each paycheck go into the plan. Employees can generally save as much or as little as they want, up to maximum annual limits set by the IRS. Employees are not required to save money in a 401(k) plan, but of course they’ll be better off in the future if they do.

Employers contributions: Employers can also contribute to the 401(k) plan, and this is one of the things that makes 401(k) plans so powerful. But employers are not required to make contributions. Some companies do it, and some don’t – it just depends on where you work and on the goals of your employer. Employer contributions can come in several different forms:

  • Matching contributions (employees only get money if they also contribute)
  • Profit-sharing contributions (everybody gets a percentage of their pay)
  • Other, more complicated, contributions

Gains and losses: after the money that you and your employer add, you may see additional increases (or decreases) in your account. These changes are due to investments (see below) and fees charged to your account.

Tax Benefits

401(k) plans are also powerful because of their tax benefits.

Reduce your income: One of the most important tax benefits is the ability to deduct contributions to the plan. When you contribute to a 401(k) plan, you can reduce your “taxable” income and pay less in income taxes as a result (by making a “pre-tax” contribution). If you’re familiar with a deductible IRA contribution, you already know how this works.

By reducing your taxable income, it gets easier to contribute to the plan (and it might make it easier to contribute enough to get the full match from your employer). Another way of thinking about the tax savings is to look at how much it really “costs” to save money in a 401(k) plan. If you contribute $100 per month, you might think that you’ll have to live with $100 less in your monthly budget. However, you might only notice $70 or $80 missing per month. Where does the difference come from? The other $30 or $20 is money that you would have had to pay for income taxes.

Now, you don’t get a tax break forever, so you’ll pay those income taxes in retirement when you take the money out and start spending it (but you won’t owe income taxes if you change jobs and transfer your 401(k) to an IRA). If, on the other hand, you prefer to pay your taxes up front, many 401(k) plans also allow after-tax or Roth contributions.

Pay taxes later: Another benefit of 401(k) plans is that you don’t have to pay income taxes on the money you earn inside of your account each year. Ideally, your account will grow as you receive interest and dividend payments, and you might even get growth out of the markets. If those things happened in a standard account without any tax benefits (as opposed to in your 401(k) account), you’d have to pay taxes on those earnings. But retirement accounts are protected, so you can keep your earnings in there and reinvest them for even more growth.

Investments in 401(k) Plans

What happens to the money in your 401(k) plan? You invest it with the goal of having it grow. Most 401(k) plans offer a variety of investments, so you have to choose what to do with your money. However, you don’t necessarily have to be an expert investor. Most 401(k) plans provide investment options that are designed to do everything for you and run on autopilot. These target date funds allow you to pick just one investment, and have your money spread out into numerous types of investments (in other words, your money is “diversified” into large companies, small companies, overseas, bonds, etc.).

Know yourself: Perhaps the most important thing you can do as you save for retirement is to figure out who you want to be as an investor. Decide if you are:

Once you know who you are as an investor, then you can select the investments that you want to use. You’ll need to know enough about the investments to pick the right one, but you can often get help from your 401(k) plan provider, or see How to Invest in a 401(k).

Getting Money Out

Of course, the big picture goal isn’t to save a bunch of money – it’s to spend that money and enjoy retirement. So how can you access your savings?

Before retirement: While you’re still working, it can be difficult to get your money. Many employers don’t allow employees any access to their 401(k) plan savings (until the employee retires, resigns, or is fired). Keep that in mind as you save money – it’s not like a savings account that you can just dip into.

In some cases, it is possible to pull money out through a loan or a “hardship” distribution (if an employer has chosen to offer those options), but those tactics should be used only as a last resort: processing those transactions can take several weeks or more, and some nasty tax surprises may come as a result (when taking a hardship distribution, or when leaving a job with a loan balance outstanding).

If you pull your savings from your 401(k) plan too early, you may have to pay income taxes (if you previously made pre-tax contributions) as well as penalty taxes. The terms “before retirement” and “too early” can be tricky: you can retire whenever you want – as long as you can afford it – so how early is too early? If you want to keep things simple, try not to use money from your 401(k) plan until you’re at least 59 1/2 years old. There are ways to get the money sooner (and avoid paying penalties), but those are a topic for another article.

During retirement: When you’re retired, you can choose what to do with the money in your 401(k) plan. Most people move their savings to an IRA in order to have more control over the money. From there, you can use any number of investments, strategies, or programs to give yourself your retirement paycheck. Or, if you don’t need the money, you can just leave it in your IRA (unless the IRS forces you to start taking a little bit out after age 70 1/2).

Details About Your 401(k)

So far we’ve covered the basics of how 401(k) plans work, but there is a lot more that you need to know before using a 401(k) plan. Every employer does things differently, so it’s important to understand exactly how your 401k(k) plan works (it might be different from your last job). Ask for a Summary Plan Description (SPD) and review that document carefully to learn more about what to expect.

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