A 401(k) is an employer sponsored plan which allows employees to defer part of their compensation for retirement.
NOTE: If your employer offers a 457 or 403(b) they work much the same way a 401(k) does and are only differentiated by who can sponsor each plan type. If you work for a state or local government, you may have a 457 plan. If you work for a tax exempt organization such as a school, hospital or religious group you may have a 403(b) plan. If you have a 457 or 403(b) all of the information below is applicable.
When you make a contribution to a 401(k) plan, the amount you contribute lowers your taxable income in the year the contribution was made. This means that “before tax” dollars are going in. This is a good thing because the money that would have been taxed on your earnings is now in your 401(k) earning you money.
The other tax benefit of a 401(k) is tax deferral. Normally, the amount you earn on any investment (stocks, bonds, interest bearing bank accounts etc.) would need to be taxed. For example: if you have a bank account which earns $100 in interest over the year, you will need to pay tax on that $100. With a 401(k) your earnings are not taxed each year. So again, the money you would have paid taxes on is still in your particular investment earning you money.
Many employers offer a 401(k) “match”. The amount they match varies, but if your company matches up to 5%, if you contribute 5% your company will put an additional 5% and 10% of your salary will go into your 401(k).
If your employer offers a 401(k) and you are not contributing, start! If you ever want to stop working and retire comfortably, you will need sizable savings. A 401(k) is a great way to save for retirement. Contact your company’s Human Resources department to find out the details and how to start contributing.
You may start your 401(k) and be overwhelmed by the investment options. This is very common and your HR department can not and will not offer any suggestion. Its important to remember that your 401(k) is not an investment. It is merely a “wrapping” around investments which provides tax advantage. You will still need to decide what investments to put your money in. This is a very personal decision and is based on a lot of factors such as age, risk tolerance and retirement target date. Take the time and do research on the investment options. This is an important decision BUT don’t let that overwhelm you to the point that you do nothing (i’ve seen this). Also be mindful of fees. Some investment options will have different fees than others. Half a percent in fees may not seem like a big deal now, but over twenty or thirty years it really will make a difference.
Determine how much of your salary you would like to contribute. If there is a match, try to at least contribute that much. If you really feel you can’t afford to contribute at all, start with 1%. You will hardly notice that missing from your paycheck. Work towards increasing that number each year. At least if you start contributing something you will get familiarized with how the 401(k) works and get in the habit of saving.