A couple looking over 401K plans

What is a 401(k) Plan?

Updated December 1, 2016 . AmFam Team

Pursuing your dreams often involves saving up — and a 401(k) plan is the perfect tool to help. We’ll teach you the basics on 401(k) plans, so you can use them to your advantage.
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!

401(k) Definition

Put simply, a 401(k) plan is an employer-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(k) plans one of the most valuable savings tools out there.

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 placed 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. Some financial advisors recommend spreading out your money into four different investments.

Employer Matching for 401(k) Plans

Additionally, many employers offer a company match, which means that your company will match your contribution, up to a certain percentage or sometimes up to a certain dollar amount.

Here’s a simple example of how a company may match by percentage:

Let’s say your employer will match whatever percentage you put towards your 401(k). So you decide to contribute 5% of your salary to your 401k, meaning your employer will match that 5%. If you make $60,000 a year, that’s 5% before taxes, which is $3,000. Your employer will contribute that same amount. 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(k) 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.

Benefits of a 401(k) Plan

Here’s a quick breakdown of the benefits of having a 401(k):

  • The amount you contribute to your 401(k) is exempt from federal income tax, so it lowers your taxable income.
  • Your 401(k) earnings accrue on a tax deferred basis.
  • Matching contribution from your employers
  • Investment customization and flexibility — you’re in control of where you want your money invested.

What Happens to Your 401(k) if You Change Jobs?

If you’re moving from one job to another, there are a number of different things you can do with your 401k:

Leave your assets in your old employer’s 401k retirement plan and start a new one at your new place of employment. Just keep in mind that many 401k plan administrators charge a fee to manage accounts, so the more you have open, the more money you could lose out on.

  • Complete a rollover to your new 401k employer. Usually this is only an option if you have another job lined up.
  • Rollover your 401k to an Individual Retirement Account (IRA).
  • Cash out the proceeds and pay taxes and the 10% penalty fee.

Why You Need a 401(k)

It’s great to have an “in the moment” mindset — life is short after all! But it’s equally important to think about your future, especially when it comes to money. A 401k is designed to help you save for your retirement years, so you’ll be financially stable in those years where you’re no longer working.

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. Looking to learn more about investing? Take a look at our investing 101 tips. Happy saving!

This article is for informational purposes only and based on information that is widely available. This information does not, and is not intended to, constitute legal or financial advice. You should contact a professional for advice specific to your situation.

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