What on Earth is a 401(k)?

Pink Piggybank With Calculator On Wooden Table

You’d be surprised at the amount of people who don’t really get what a 401(k) is. Even professionals who’ve been working “big kid jobs” for years may not be familiar with their company-provided 401(k). Hell, I had no idea how a 401(k) worked until I realized a percentage of my paycheck was automatically going into one. You aren’t alone.

So…what is a 401(k), exactly?

A 401(k) is a type of retirement plan offered by your employer. Some employers will require you to be employed for a set period of time before you choose to enroll. Others may automatically enroll you upon employment, so you may want to check your paystub if you think you’re missing some extra dollars from your paycheck.

Any contributions you make to your 401(k) are spared from income tax, leaving a nice hunk of cash for your retirement years. While the money is in your 401(k), it’s free from taxation; however, your withdrawals will be taxed according to your income bracket upon retirement. The earliest you can start taking money from your 401(k) is the ripe old age of 59 ½.  

I’m in my twenties. Why do I need to save now?

You ought to be contributing to your 401(k) as early as possible. The logic is simple: saving earlier means you’ll have more for retirement.  As of 2015, the maximum contribution limit (for people under 50) is $18,000 per year. The recommended contribution amount is 10% of your annual salary, so if you’re making $35,000 a year, you ought to put $3,500 into your 401(k).

But let’s be real here. Between the burden of student debt and other essential expenses, most of us are reluctant to put a chunk of our paycheck into a no-touch retirement account. And if you’re like me, you don’t have $18,000 to contribute to expenses, let alone a 401(k). If you treat your 401(k) like a savings account and make an early withdrawal, you’ll be slammed with a 10% penalty on your withdrawal in addition to income tax. Ouch.

Thankfully, you won’t be building your retirement fund alone. Most employers will match your contributions up to a certain amount, typically half of your contributions up to a percentage of your salary. If you’re lucky, your employer may match 100% of your contributions up to a certain percentage. Even if you aren’t in a spot where you can devote 10% of your paycheck to your 401(k), try to match your employer’s contribution limit.

Say your employer will match 100% of your contributions up to 3% of your annual salary of $35,000. For every dollar you contribute to your 401(k), your employer will pitch in a buck too–up to $1,050. Contribute $1,050 over the course of a year and you’ll have $2,100 in your 401(k). You’re basically doubling your money! Who doesn’t love that?

What else can I do with my 401(k)?

Most people use their 401(k) to invest. You won’t be touching that money until you’re retirement age anyway, so it’s a perfect account for letting investments grow. When you’re investing with your 401(k) funds, the most popular avenues are stocks and bonds. Bonds aren’t as risky as stocks; they’re technically debts that you buy from a company. You earn interest on a percentage of the bond’s face value, and after a maturity period, you’ll receive the actual worth of the bond.

Stocks, on the other hand, aren’t safe in the present. However, they tend to yield the best long-term profits. In the meantime, your short-term losses may cause a premature gray hair or two. Everything should be fine by the time you’re ready to dip into your retirement fund. And get this: the sooner you start investing, the more time your money will have to compound.

Do I keep the same 401(k) forever?

When you’re ready to move onto your next career adventure, you have a few options on what you can do with your 401(k). Here are three options, in order of “worst” to “best” idea.

  • Cash out.
    You’ve got a sweet new job lined up and you’re ready to kiss your old position goodbye. In fact, you’re so ready that you decide to cash out your old 401(k). This is the worst idea out of the three I’m going to list because not only will you have to pay income tax on the money, you’ll be subject to the 10% early withdrawal fee. If you have a sizable amount saved up, you’re going to lose thousands of dollars in penalties. Bad idea.
  • Consolidate your old 401(k) into your employer’s plan.
    Much better idea. Before you do this, check the guidelines of your employer’s 401(k) plan.
  • Rollover your 401(k) into an IRA.
    Also a good idea. A Rollover IRA is another type of retirement plan. Like your 401(k), contributions are tax-deferred until retirement. Unlike your 401(k), you can contribute as much as you want, so feel free to put in the $50,000 you have lying around (or send it to me). Early withdrawals are also penalized. However, you have some wiggle-room. You can make an early withdrawal if you use the money for certain expenses, such as buying your first home or going back to school.

Are you still with me?

All in all, you should look at your expenses, debts, and income and determine how much you can comfortably contribute to your 401(k). You may want to start several years down the line, when you’re a financially stable 30-something instead of a 20-something trying to get it together.

Think of it this way: when you’re 30ish, you’re going to have so much more on your plate. You probably see yourself with a higher salary. You may also have a mortgage payment, lingering student loan debt, and children (if that’s your thing). Take advantage of your financial freedom and put something away in your 401(k), even if it’s 5% or less of your paycheck. Every little bit counts.

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