What is a 401K Plan?
You’ve heard the term 401(k) before, but what exactly is it? Well, for starters, it’s a great way to help you achieve that dream of buying a home, retiring, and living comfortably. A 401(k) plan is one of the most valuable financial assets to have, which is why we’re taking you on a quick crash course of the basics. Let’s break it down:
What is a 401(k)?
Put simply, a 401 plan is an employee-sponsored retirement savings plan. Through these plans, you can save money towards retirement on a tax-deferred basis, which means you don’t pay federal or state income taxes on your savings or their investment earnings, until you withdraw the money at retirement.
And since most people’s taxable income is lower at retirement than during employment, they end up paying less in taxes on this type of savings — which makes 401 plans one the most valuable savings tools out there.
There are a few different types of 401 plans — each aimed at a different audience. Here are a few of the most common 401 plans:
401(k). These plans are offered to employees of public or private for-profit companies.
403(b). These plans are offered to employees of non-profit or tax-exempt organizations, like public schools, colleges, libraries, churches, hospitals, and philanthropic organizations.
457. These plans are offered to employees of state and local municipal governments — along with some local school and state university systems.
How do 401(k) Plans Work?
Now for the fun part! So with a regular 401(k) plan, money is deducted from your paycheck before taxes are taken out, which in turn lowers your taxable income and therefore, lowers your taxes. The money is then place into your 401(k). With the 401(k), you decide how your money is invested. Most plans offer a variety of mutual funds, which are made up of stocks, bonds, and money market investments.
Additionally, many employers offer a company match, which means that your company will match your contribution, up to a certain percentage. That’s why it’s important to contribute at least enough to take advantage of your company’s match in full. Free money is always good, right?
However, keep in mind that 401(k) plans also come with restrictions. In many cases, you can’t tap into your company’s contributions immediately after you’re hired; you must wait a certain amount of time — a period called vesting. The IRS also limits the amount of money you can put into your 401 savings, depending on your age and salary. There are also rules on when you can withdraw your money, and you can face penalties for pulling out funds before you reach retirement age.
As you can see, 401(k) plans can be pretty complex, but are well worth the effort. However, each 401(k) plan is slightly different, so it’s best to talk with a financial advisor, a banking professional or your company’s HR department to get the specific details of your plan. Happy saving!