The 401k plan is the most common retirement savings plan sponsored by employers across the United States. Named for the section of the tax code that governs them, 401k plans let workers save for their retirement using pretax dollars that grow tax-free until the money is withdrawn during their retirement years.
There are many benefits to using a 401k plan for retirement savings that make them an attractive financial instrument for millions of workers around the nation. Here are some of the basics of 401k plans that everyone should know.
Contributions
Contributions to a 401k plan are taken out of the worker’s paycheck before the money is taxed, lowering the worker’s taxable income by the amount of the contribution. This results in lower taxes being paid during their working years. The money is not taxed until it is withdrawn from the account after the worker has reached retirement age. Hefty tax penalties are imposed on withdrawals made before this time, so it is important to avoid withdrawals from the plan until it is the right time to do so.
Matching Contributions
Many employers offer matching contributions for money placed in the account by their employee, typically up to 3 percent of the employee’s salary. The workers that do the best with 401k plans invest enough to get the full matching amount that the company pays to match their contributions. However, it often takes several years of employment before the employee is eligible for the entire amount contributed by their employer, generally a period of three to five years. If the employee leaves the company before this time period is up, a portion of the amount contributed by the employer is returned to the company.
Investing
You decide how your money is invested with a 401k plan. Most plans offer a variety of mutual funds composed of stocks, bonds, and money market investments to choose from and you select the ones that you want to invest in. Many of these plans also offer target-date funds, a combination of stocks and bonds that become more conservative over time as you reach your target retirement date.