What is a 401(k)?

What is a 401(k)?

Photo by 401k 2013

As I have written previously I work with a lot of college students in our church as a part of my ministry there.  There are always questions about 401(k)s; What they are how they work.  The fact is that many people simply don’t understand this very important retirement vehicle.

So, what is a 401(k)?  It is a savings plan named after the section of the law that created it.  It allows an employee to take a portion of their pre-tax income, up to $17,500 for 2013,(Those over 50 are allowed to add $5,500 to that amount) to a qualified employer sponsored investment plan.  Many employers choose to match their employees contributions to some degree adding additional money to the pot.

So, what do those things mean?  Pre-tax dollars means that the money contributed to your 401k are not counted as income when you are taxed.  If your paycheck was $1000 and you contribute $100 to your 401k then you only pay taxes on $900. ($1000-$100)  This allows you to save money up front on taxes.  Because you will pay taxes on the money when you retire it is called a tax deferred plan.  This also begs the question “Will taxes be higher now or when I retire”  I would guess taxes have no where to go but up since we are only paying for 2/3 of the government we have now and we will eventually have to pay for the remainder.

Employer match

This is one of the sexiest aspects of the 401k plan.  With the average 401k plan employers contributed 4% of the employee’s salary most commonly in the form of a direct match.  An employer will match dollar for dollar every dollar an employee contributes up to a certain percent, the average is 4%.  Meaning that if Joe contributes 4% of his paycheck to his 401k the company contributes the same amount to his 401k.  This work out to be a 100% return on investment; Joe doubles the money in his 401k.

Not all employers do a direct percentage match some match $.50 on the dollar or some other amount but knowing how your 401k plan works is important to making the most of your plan.  As in our above example Joe’s employer matches up to 4% of his salary.  This means that if Joe is contributing less than 4% to his own retirement then he leaving his employers money on the table.

Getting your money out of your 401(k)

Getting your money out of a 401(k) can be difficult or have penalties depending on the circumstances of your plan.  Traditionally, you can only make withdraws from a 401(k)  under certain circumstances.

• When the employee retires, becomes disabled or is no longer employed by the employer who sponsored the plan.
• The employee hits age 59.5
• The employee experiences a hardship as defined under the plan, if the plan permits hardship withdrawals
• Upon the termination of the plan

With some plans it is possible to take a loan of 50% of the vested value of the account but not all plans allow for this option.

Summary

A 401(k) is a retirement plan that has some great aspects and that also has some drawbacks.

Pros:

• Most employers contribute additional money to the retirement of the employee.
• Tax benefits.

Cons:

• Mandatory withdraws at age 70.5
• Taxes are likely to be higher when you actually have to pay them on the money in the account unless you believe you will be in a lower tax bracket when you are pulling money from your account.

Obviously, I can’t cover everything there is about 401(k)s but hopefully this gives a basic idea about what they are and how they are used.

Photo by  401k 2013