What Is A 401k? How to Invest For Your Future Retirement

By Todd Kunsman

Money Basics

Published on

Updated on

One of the best decisions you can make is investing in your company 401k. 

While you might not understand it completely, when your employer offers one you should immediately sign-up for it and contribute. 

When I got my first job after college in 2010, I had no clue what a 401k was. My parents told me to sign-up and that it is for your future retirement. 

While I shrugged it off a bit, fast forward a few years later and I was really diving in and learning what a 401k exactly is and why it matters.

What is a 401k and How Does It Work?

As part of the money basic series, I wanted to cover the definition of a 401k and how it works. So to get us started, I’m going to quickly explain what a 401k is. 

A 401k or 401(k) is a tax-advantaged account created by the government in the late 1970s and it is used to contribute money for your future retirement.

Many companies offer a plan for their employees to contribute a defined percentage of their salaries towards. 

This money and investment earnings are not taxed until you begin to withdrawal during your retirement.

You can potentially cash out this money early, but you’ll pay early withdrawal fees and you’re doing your future retirement a disservice. 

Additionally, many employers will offer a company match on your contributions. 

What does that mean?

Well, your company will contribute money up to a certain amount or percentage based on your contribution. Which means, free money is added to your 401k!

Each company and 401k plan is slightly different but some common contributions are:

  • For every dollar you invest, 50 cents is added by your company up to X% of your pay. Typically that’s 6%.
  • Or they match dollar to dollar for up to 3% of your pay. 

The important takeaway here is that you should always contribute enough to take advantage of your company’s employer match (if they offer one). 

How does it work?

To keep this simple, here is how your 401k plan works in a few simple steps.

There is plenty more information out there, but this will help you with the right amount of knowledge.

  • Your company sends you info to sign-up. Sometimes you can start one right away, other times it might be after you’ve been with the company six months or a year.
  • You’ll pick the percentage of your paycheck to contribute to the retirement plan you sign-up for (always ensure you contribute enough to get the company match at a minimum).
  • Then, you’ll be tasked with choosing the investment funds. Ideally, you’ll want to keep this simple. It’s okay if you don’t know how to pick these yet, you can go with a simple target-date retirement fund (the year you’ll be retiring). You can always adjust the fund types later.
  • These investments follow the stock market and prices will fluctuate. Pending your investment choices, you’ll grow money through dividends, capital gains, and continued contributions and company matches.
  • Additionally, you can elect to contribute more as you get raises or when you understand your plan better.
  • When you want to withdraw for retirement, you must be 59.5 years or older, to avoid early withdraw penalties. Typically, you’ll want to target withdrawal rates of 4-5% of your total amount per year. Which you can adjust as you go and for inflation.

The Types of 401k Accounts

There are actually a few types of 401k accounts that exist. While I won’t go into massive detail about each one, below are the ones you should know about. 

  • Traditional 401k: The most common 401k employers tend to offer and you’ll invest in the funds that are within this plan.
  • Self-directed 401k: Similar to the traditional 401k, but employees have more investment options than just what is included in the traditional.  
  • Safe-harbor 401k: Contributions from employers are fully vested right away and there are different employer contribution limits compared to the previous two. 
  • SIMPLE 401k: A 401k plan for companies who have under 100 employees, basically for small businesses.  
  • Roth 401k: Compared to the other plans, this one is a fairly new option.  This plan is for those who think they will be in a higher tax bracket in the future. While not easy to predict or know, some will opt for this if it is an option at your company. 
  • Tiered-Profit Sharing 401k: If your company is under 50 employees, they may do profit sharing contributions instead.

Lastly, if you work for the government agency or a non-profit, you might have something known as a 403(b) plan as you are not eligible for any of the 401k options above.

The Benefits of a 401k

Based on the definition of a 401k, you probably have a good idea about the benefits of investing in one.

But to ensure you really understand the value, I’ll list all the advantages of investing in a 401k here.

Benefits for Employees

Since this is about you, the individual, I’m going to start with the advantages of investing in a 401k for employees. 

  • Boost financial security for retirement
  • Contributions added automatically via your paycheck
  • Can reduce your current taxable income
  • Your investment earnings are not taxed until withdrawal
  • Starting early allows compound interest to grow significantly 
  • You can rollover that money to other 401ks or retirement accounts
  • Free money if your company offers a company match, accelerating results

Benefits for Businesses

And while 401k plans benefit individuals, they also offer incentives for businesses who take part in offering one to employees.

This is a win-win situation for both sides. 

  • Helps attract top talent and employees when a great 401k is offered
  • Tax incentives for the business
  • Affordable and flexible plan options no matter company size

It’s important to note that each type of 401k plan offers various advantages and also disadvantages. 

Some of the negatives of these plans is the inability to withdrawal early for certain situations, taxed when you withdraw many years later when you have a potentially high amount saved, and some plans have high fees. 

However, everyone should ensure they are enrolled and contributing to a 401k as the pros outweigh the cons. 

But, it’s important for you to know your own financial goals and understand the impact these 401k plans can have on your future. 

Blooom is an online investment adviser that helps manage individual participant accounts in employer sponsored retirement plans. Sign-up for free to get 401k portfolio analysis with recommendations and uncover any hidden fees. They also offer management services for a flat fee to help you get the most out of your investments if you need further help. 

Some 401k FAQs

Now that you have a decent understanding of what a 401k is all about, there are still some questions you might have.

Can you lose your 401k?

If the company you work for is closing or filing for bankruptcy, you might be concerned that you will lose the money in your 401k.

However, any money you contributed from your salary is protected and legally yours. 

Employers must legally keep 401k funds separate from the company assets. But, any money that was contributed as a match by your employer that has not vested may not be yours. 

What happens to my 401k if I leave my job?

If you leave your current employer, you have a few options with your 401k.

  • Leave it in the existing plan (you’ll still have access)
  • Move the money over to your new employer plan
  • Roll it over into your own IRA that you open up
  • Cash out the money

Ideally, you want to take advantage of the first three tax incentive options, but it’s up to you. Just be aware of timelines and taxes you may owe. 

What happens to my 401k if I die?

In your 401k plan, you will add a primary beneficiary and secondary beneficiaries to your account. If you die before you reach retirement, this money will go to your beneficiary. If that person also has died, it then is distributed to your secondary beneficiary. 

When you die during your retirement, the funds then go to your estate.

Can I contribute 100% of my salary to my 401k?

There are yearly maximum limits that are set by the IRS. For 2019, for example, the maximum limit you can contribute was $19,000.

This number tends to rise pending the IRS announcements, so certainly pay attention each year to see if you can contribute more. 

Also, if you are over 50 the IRS allows you to contribute a bit more to either play catch up or amp up your retirement funds as you get closer. Additionally, there may be more rules and regulations for high earners. 

How much should I have in my 401k?

This number depends on factors like your age, when you want to retire by, and how much you’re investing.

The obvious answer here is the more you can invest, the better for your future. Plus, the earlier you start the more compound interest works for you. 

Ideally, you’ll want to invest enough to get any company match your employer offers. And the common recommendation is 10% of your salary or more should be contributed to your 401k.

Final Thoughts

There you have it, everything you need to know about 401k plans! 

While I covered quite a bit, there are certainly more areas you may want to explore further. Like the types of funds to invest in and how much you personally need to save. 

But, the above should get you on the right financial track and prepare you for future retirement. 

What other questions do you have about these retirement plans? Are you investing in one currently? Planning on investing one soon? Let me know in the comments below!