What is a 401(k) retirement plan? Understand the basics in 6 steps 💸

Ever thought of turning the change in your pocket into a future fortune? With a 401(k) plan, you can use time to have a lot of money when you retire.

A pair of hands placing coins into a pile.

1. What is a 401(k) plan?

Definition:

A 401(k) is a type of retirement savings plan provided by employers in the United States. It's named after a section of the Internal Revenue Code.

How it works:

You, as an employee, can contribute a portion of your salary to the 401(k) on a pre-tax basis. This money is invested, and it grows over time.

An animation depicting growing stacks of coins and bils.

Did you know?

A 401(k) is connected to your job, and you can only have one if your employer offers it.

2. Investment Choices

You can choose how your money is invested based on your risk tolerance and time horizon (when you want to retire). 401(k) plans usually offer a range of investment options:

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Stocks

A stock is a tiny piece of ownership in a company. When you own a stock, you own a share of that company, and you might get a part of its profits if the company does well.

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Bonds

Bonds are like IOUs, where you lend money to a company or government. In return, they promise to pay you back the borrowed money with a little extra (interest) over time.

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Mutual Funds

A mutual fund is a teamwork approach to investing. People pool their money, and a manager takes care of buying a mix of stocks, bonds, or other investments. Profits or losses are shared among the group.

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Exchange-traded Fund (ETF)

An ETF is like a basket of different investments, such as stocks or bonds, all packed into one. Buying shares of an ETF lets you own a piece of that whole basket.

Did you know?

There are target-date mutual funds that automatically adjust their investments over time to fit your retirement goals, getting less risky as you get closer to retirement.

3. Employee Contributions

You can contribute a portion of your salary to the 401(k) before taxes are taken out. This reduces your taxable income, so you pay less income tax, which ultimately helps you save more for retirement.

A hand putting a coin in in a piggy bank.

Did you know?

In a 401(k), there's a maximum amount you're allowed to contribute each year. For example: in 2023, the contribution limit was $22,500.

4. Employer Matching

Some employers offer to match a percentage of your 401(k) contributions. This is essentially free money added to your retirement savings.

Vesting Period

If your employer offers a matching contribution, there may be a vesting period. Vesting refers to how long you must work for the company before the matching funds are entirely yours.

Two hands on a digital screen. They come together, flash, and the word 'Match' appears.

Quiz

Jenny's employer offers to match 50% of her 401(k) contributions up to 5% of her salary. Jenny decides to contribute 4% of her salary to her 401(k). What does this mean for Jenny?

Jenny receives a 4% match on her salary

Jenny receives a 5% match on her salary

Jenny receives a 2% match on her salary

Jenny receives a 50% match on her salary

Did you know?

Companies are free to choose if they want to make staff wait before taking ownership of the money the company pays into 401(k)s.

5. Withdrawals

Since 401(k) savings are for retirement, it's best to avoid withdrawing before a certain age to avoid penalties.

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Age Restrictions

You typically can't withdraw money from your 401(k) before the age of 59½ without incurring penalties.

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Early Withdrawals

There are some exceptions for early withdrawals, but they often come with penalties and taxes.

A woman wags her finger and says, 'No no no.'

6. Why Start Early?

Compound interest: The earlier you start contributing, the more time your money has to grow through compound interest.
Long-term savings: A 401(k) is a long-term savings tool for retirement. Starting early helps you build a significant nest egg.
Take advantage of market fluctuations: Starting to invest early means your money has more time to handle the good and bad times in the stock market. In the long run, the ups and downs tend to even out.

An old man throws bills around.

Quiz

Two friends save $100 each month for retirement. One starts at 25, and the other starts at 35. By the time they reach 65, who is likely to have almost double the savings?

The one who starts at 25

The one who starts at 35

Both will have the same savings

It doesn't matter when they start

Take Action

David Hasselhoff says, 'Then, you better get started.'

Take these next steps to make the most of your 401(k) savings:

Check out this Byte: How do I invest my savings for short-term and long-term financial goals?

Start early: The power of compounding works best when you start saving early.

Contribute regularly: Consistent contributions, even if small, can make a big difference over time.

Understand your investments: Learn about the investment options available and choose a mix that aligns with your goals.

Take advantage of employer matching: If your employer offers a match, contribute enough to get the full benefit.

What is a 401(k) retirement plan? Understand the basics in 6 steps 💸

1. What is a 401(k) plan?

Definition:

How it works:

Did you know?

2. Investment Choices

Stocks

Bonds

Mutual Funds

Exchange-traded Fund (ETF)

Did you know?

3. Employee Contributions

Did you know?

4. Employer Matching

Vesting Period

Quiz

Did you know?

5. Withdrawals

Age Restrictions

Early Withdrawals

6. Why Start Early?

Quiz

Take Action

Take these next steps to make the most of your 401(k) savings:

This Byte has been authored by

Corey Bright