Nearly everyone has heard someone mention “401k” at some point in their lives.  Chances are if you are reading this you have at least an idea of what it is, and if you don’t, you will soon! 

So what exactly is a 401(k)?

The 401(k) plan is a type of retirement plan that is named after a section of the U.S. Internal Revenue Code.  It is a plan that is employer sponsored that allows you the worker to save income from your paycheck before taxes are taken out by the government.  Now, this doesnt mean you won’t have to pay taxes on it, our kind and generous government simply doesn’t take out taxes right now but when you actually collect your money at retirement. This is what people mean when they say it is tax deferred. 

Generally this money is then put into an account that can be invested in an assortment of mutual funds that can emphasize stocks, bonds, money market investments. Most 401ks are what is called participant-directed meaning that the employee is the one who gets to allocate the money.  There is another, less common scenario called trustee-directed where the employer has trustees who decide how the money will be invested.

Another very important point is that most companys match a portion of the employee contribution.  For example a company might match 1% for every 2% contribution up to 6%.  In this case if the employee contributed 6% per paycheck, the company would contribute 3%. This is one area where the 401k is vastly superior to other traditional retirement plans.

When can you withdraw the money?

There is a long answer, but the short answer is 59½. If you withdraw the money before then there is an extra tax on it of 10% and this is only under very specific circumstances.  Its not meant to be something that you can take money out of because you want to buy a boat or pay off some credit cards or go to south padre island…  It is meant to be something that is saved for retirement.

Whats the deal with the taxes?

The employee does not pay federal income tax on the amount of current income that he or she defers to a 401k.  So if you earn 30,000 in a year, and defer $2000 into a 401k plan, you only pay taxes on $28,000 that year.  Assuming a yearly return of 8% (which is actually lower than the market average over the last 100 years), if you are 25 when you put that money in, by retirement that 2000 will have become $30,000 and only then is it taxed. 

What happens if I leave my job?

Your 401(k) plan can be “rolled over” into the new job’s 401(k) plan, an IRA, or it can be cashed out.  However, cashing out is a terrible idea….all that money could have sat and compounded.

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