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What is a 401(k)?

What is a 401(k)?

  • Posted by Admin
  • On April 29, 2016
  • 2 Comments

Congratulations, you have a 401(k)! If you’re thinking, “I know this is a good thing, but I don’t know how it all works,” then this article is for you.

A 401(k) is an account in which you save money during your working years, and then withdraw from during your retirement. The money is invested in a mix of stocks and bonds that you choose, and it will grow from your contributions and earnings. It can only be offered by an employer (which can include you if you are self-employed).

The 401(k) is named for its section in the IRS code and is the account used by the private sector. The government or non-profit companies use a range of equivalent plans, some called a 403(b) or 457. Either way, it is a tax-qualified, defined contribution pension account. Let’s break that down further.

Tax-qualified means that the money is “before tax” money. You can invest a portion of your pay before taxes are taken out. In a way, just by investing in your 401k now, you’ve already made a little extra money by not paying taxes immediately on that income.

Defined contribution means that you will choose the amount that you transfer each month, pre-tax, to the account. Your employer may also fund your 401(k) account too, usually by giving an amount that matches all or part of your contributions (FREE MONEY!). In 2016, the maximum you can contribute is $18K ($24K if you’re 50 or older). Depending on how the plan is set up, you may be able to make post-tax contributions too.

A pension is a regular payment made to you during your retirement from an investment fund which had been growing during your working years.

You get to put in pre-tax money, let it grow for all your working years and then have your nest egg when you retire. Sounds great, but what’s the catch? You will pay income taxes on your withdrawals during retirement. Generally speaking, any withdrawals before age 59 ½ will carry an extra 10% penalty.

Here are some other good-to-knows about the 401(k) plan:

  • Many plans allow you to take a loan against your contributions of 50% of the balance. The loan repayment comes out of your paycheck automatically and if you stay at your job, you’ll have 5 years to repay. This is usually not the first option you’ll take if you need a loan, but it’s good to know that the money isn’t absolutely locked away until retirement.
  • If you take a loan from your 401(k) for a home purchase, the repayment term can be up to 15 years.
  • Each plan charges a fee for operating expenses, usually expressed as a percentage called the Expense Ratio. The lower the expense ratio, the less you pay to invest.
  • You can do post-tax contributions, meaning you put in money that has already been taxed but get the advantage of withdrawing that money and the associated earnings tax-free during retirement.

The earlier you start saving in your 401(k), the more you’ll have upon retirement! If you are offered a matching contribution from your employer, it’s a good idea to put in enough to get the full match.

For example, if you earn $80K per year and your employer will match up to 3% of your salary to your 401(k), you can save just $2,400 a year and get the full $2,400 match for a total of $4,800 in Year 1. Assuming you have a 6% return on the investment and do the same in Year 2, you’ll have a total of $9,888 but you’ve only used $4,800 of your own money. Don’t forget, you didn’t pay taxes on that $4,800 either! What a deal!

Get a head start on your retirement savings by utilizing your 401(k) with your employer. The details and tax implications can be complex. A financial advisor is a great resource to help you determine how much to save now for the retirement that you desire and to answer any other related questions you may have. Happy saving!

 

Looking for more guidance with your 401(k)? Dragon Financial Group is happy to help. Contact us or schedule an appointment here. 

 

 

The commentary on this blog reflects the personal opinions, viewpoints and analyses of the Dragon Financial Group employees providing such comments, and should not be regarded as a description of advisory services provided by Dragon Financial Group or performance returns of any Dragon Financial Group clients. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Dragon Financial Group manages its client accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.

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2 Comments

Bruce
I passed this on to my grand kids (18 - 22)! I want them to start as soon as they begin their earnings pool. This will help to encourage.
Guy Agrati
I found the blog to be a good if superficial intro to 401s. From my perspective equating a 401 with a pension is a stretch. Pensions are generally considered defined benefit, i.e., regularly scheduled payments of equal amounts. A defined contribution plan is yours to take as you will, upon reaching retirement age. The blog does not discuss vesting of the employers contribution, certainly an important piece of information, even in an introductory discussion. Also missing is any discussion of required minimum distribution, upon reaching age 70 1/2. Finally,a comparison of 401 with IRAs would be helpful. Adding links to more thorough treatments might be a good idea, such as the IRS web page.

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