What is a 401(k)?

Great question! And, if you’re lucky enough to work for an employer who offers one, here’s what you should know.

A 401(k) is a company sponsored retirement plan. Each time you get paid, you can deduct money from your paycheck to automatically save and invest for your retirement. In a 401(k), you and your employer can both contribute money towards your retirement (not all employers offer a match).

There are two main types of 401(k)s:

• A Traditional 401(k): This is the most common type of 401(k). Your contributions are made pre-tax, which means you don’t pay taxes on any of the money when you add it to the plan. Taxes are paid on distributions you make as you withdraw money from the account in retirement. Since you are not paying taxes on the money before investing it in the account, this means more of your paycheck gets invested and can be growing over time.
• A Roth 401(k): Not all plans offer a Roth 401(k) option, but most ForUsAll plans do! Your contributions are made after taxes, and distributions in retirement are not taxed as income. Once you reach retirement, you get to pull both your contributions and your investment earnings out tax-free since the contributions were already taxed before they were invested in the account.

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Why Should I Use a 401(k)?

A huge benefit of the 401(k) is that it allows you to put a lot of money away for retirement in a tax-advantaged way. Meaning, any money that is placed into this account escapes taxes while it grows.

The annual contribution limit to your 401(k) is $19,000 for tax year 2019, with an extra $6,000 allowed as a catch-up contribution if you are at least 50 years old.

Traditional 401(k) Contributions: Since these are pre-tax contributions, you won’t see a dollar for dollar difference in your paycheck when you contribute pre-tax dollars to an account. You can designate your 401(k) contributions in percentages of your salary or as a dollar amount. For this example, let’s use a dollar amount. Let’s assume you decide to contribute $85 per paycheck to the account. $85 pretax WILL NOT mean your paycheck is missing $85 dollars. The amount you see missing from your check may be closer to $60. And let’s be honest, the money is not “missing;” it is still your money, you still earned it and you still keep it, but instead of spending it today, you are investing it for your future to help offset your living costs when you are no longer clocking in at a 9-5 job.

Roth 401(k) Contributions: Ok, this one does have a dollar for dollar impact on your net paycheck. But here, you have to remember that you are paying taxes on this money now. The only difference is that instead of all your money going straight to your bank account, an amount from your check is instead routed to your 401(k), where it can be invested for long-term accumulation and growth.

Aside from the ability for you to save a lot towards your retirement, check to see if your employer offers a match. Some employers who offer a 401(k) plan also make a matching contribution, which means as you contribute toward your future, your employer will too! The majority of matches will be between 50% to 100% of your contributions, up to a limit that typically falls between 3% and 6% of your annual income. If your employer offers a match, consider it free money! For most employer contributions, you are only eligible to receive the money if you contribute to the plan. Some employer contributions may be subject to vesting, but you are always 100% vested in your own contributions. To take full advantage of a company match benefit, you’ll want to contribute at least up to the match amount.

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