What is a 401(k)?

Welcome back to our What Is? series of posts. Today, we’ll tackle an exciting topic with a snooze-fest name — the 401(k).

The term 401(k) may look like something out of Algebra class, but it’s actually one the most important perks any job can offer.

More important than free food and a foos-ball table?

Oh yeah.

What is this mysterious number-letter combo and why does it matter so much?

401 huh?

Very simply, a 401(k) is a type of retirement account. Retirement accounts are designed to help you save money while you’re working to live off after you retire.

The name “401(k)” comes from the section of the Internal Revenue Service (IRS) rules that defines the rules for this account.

As of this year, you are allowed to contribute any amount up to $18,000 a year to a 401(k).

What’s the big deal?

These accounts are awesome for several reasons.

Reason #1:

If you sign up for your employer’s 401(k), you can assign a percent of every paycheck to be automatically put into that account. This means that money is safely squirreled away where you’ll never miss it. You’ll be saving with basically no effort on your end.

Reason #2:

Your 401(k) contributions are taken from your salary pre-tax, or before your income taxes are taken out. This lowers your income in the eyes of the IRS, which in turn lowers the amount of money used to calculate your taxes. So, by contributing to your retirement, you could also be saving your current self some moolah in taxes. When you retire and start withdrawing that money from your account, you will have to pay income tax on it, but you won’t be working, so ya know, it’s still not a bad deal.

Reason #3:

Probably the best thing about 401(k) accounts is that employers who offer a 401(k) usually “match” a certain percent of your contribution. What does that mean? If your employer matches up to 3% of your 401(k), that means that the first 3% of your salary you assign to be put into your 401(k) will be doubled by your employer, so you are effectively contributing 6%. That money is in addition to your salary and won’t be taxed until you withdraw it.

Let’s look at some numbers.

Say you earn about $35,000, and you contribute 3% of your salary to your 401(k). That works out to be about $1,050 a year. If your employer matches that 3%, you’ll actually be getting $2,100 a year going into your retirement account.

If you contribute more than 3%, good for you, but your employer will only match that first 3%.

How amazing is that? You’re essentially doubling your retirement contribution by taking advantage of your 401(k) — free money!

free money simpsons

What happens to that money?

When you sign up for a 401(k), you will usually be given a list of funds that you can choose to invest your 401(k) money in. Once you’ve done your research and chosen a fund or two, your money will be invested and will start to work for you, growing even beyond what you are contributing.

Once you reach age 59.5, you will be able to start taking that money out of the 401(k). If you take it out before then, however, you will be hit with a 10% fee, so try to imagine that money as off-limits until retirement.

Other types of accounts

Some professions have retirement plans that are different from a 401(k). If you work for a non-profit or for the government, for example, your retirement accounts will have different names.

Teachers and non-profit employees are often offered a 403(b) plan — named, shockingly, after section 403(b) in the tax code — which allows similar contributions to an account. These accounts work differently from a 401(k), however. We won’t delve into them in this post, but the fees and rules around each type of retirement account can vary significantly, so educate yourself on what those are before signing up for any account.

Can I wait to open my 401(k)?

No. Why would you?

It’s a lot to think about when I’m starting a new job.

Better to get the paperwork out of the way when you’re filling out all the other forms for your job than put it off for some mythical future date when you’ll magically have time.

I’m making so little money! Won’t it be better to wait until I make more?

If you start right away, you’ll never miss the money that comes out of your check, and you’ll be taking advantage of your most valuable asset — time. The longer you give that money time to grow in your account, the more money you’ll end up with down the line.

What if I need every penny?

Even if your starting salary is tiny, try to assign at least a percent or two for retirement. That’s about $200 a year from a $20,000 salary, or $17 a month. You can do this.

Future-you will thank you.

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