What Is a 401(k)?
Retirement can feel like a problem for Future You.
When you are trying to pay rent, keep the lights on, pay down debt, or figure out how to stretch your paycheck until the next one, putting money away for something decades away can feel almost impossible. Retirement might be important, but there are plenty of things happening right now that need your attention.
A 401(k) is one of the most common ways employees save for retirement. If your employer offers one, you may have seen the option when filling out new-hire paperwork or noticed a deduction on your paycheck without really knowing what it was doing.
Understanding how a 401(k) works gives you a starting point. You do not need to become an investing expert overnight, and you do not need a huge paycheck to learn how the account works. The first step is simply knowing what you are looking at.
What Is a 401(k)?
A 401(k) is an employer-sponsored retirement account. Your employer provides access to the plan, and you can choose to have part of your paycheck contributed to the account.
The money in the account is generally invested rather than sitting in a regular checking or savings account. Those investments can grow over time, which is where the long-term benefit of retirement investing comes from.
For example, imagine you earn $2,500 per month and choose to contribute 3% of your pay. About $75 would go toward your 401(k) each month before considering the specific tax treatment of your contributions.
You generally do not have to remember to transfer the money yourself. Your contribution is deducted from your paycheck and sent to the retirement plan automatically.
That automatic process is one reason workplace retirement plans can be useful. Once you choose your contribution, saving can become part of your normal paycheck routine instead of another bill you have to remember to pay.
Traditional vs. Roth 401(k)
You may have a choice between traditional and Roth contributions, depending on what your employer's plan offers.
With a traditional 401(k), contributions are generally made before federal income taxes are applied to that money. You receive the potential tax benefit now, and withdrawals are generally taxed as income later.
With a Roth 401(k), contributions are made with money that has already been taxed. Qualified withdrawals later are generally tax-free.
The important thing is knowing what the two choices actually mean before selecting one.
In our article The Difference of Roth IRA vs. Traditional IRA we go more in depth on the differences.
How Much Should You Contribute?
This is where retirement advice can become frustrating.
You will find plenty of rules telling you that you should save a certain percentage of every paycheck. Those numbers can be useful as general goals, but they do not account for everyone's actual life.
Someone making $90,000 with inexpensive housing has a very different financial situation from someone making $35,000 while paying most of their income toward rent, transportation, food, and other necessities.
If you can comfortably contribute 10%, great. If you can contribute 5%, that's something. If you can only afford $10 per paycheck right now, that is still a starting point.
You can also increase your contribution later. Maybe you get a raise and decide to put an extra 1% toward retirement. Maybe you finish paying off a credit card and redirect some of that money. Your contribution does not have to stay at the same amount forever.
Some employers also contribute money to your 401(k) when you contribute your own money. This is called an employer match.
For example, an employer might say that it will match 50% of your contributions on the first 6% of your salary that you contribute.
If you earn $40,000 and contribute 6% of your salary, you would contribute $2,400 over the year. A 50% employer match on that amount would add another $1,200 to your account, assuming you meet the plan's requirements.
The exact formula varies by employer, so read the plan information rather than assuming every company matches contributions the same way.
You may also see the word "vesting." Vesting determines when employer contributions officially become yours to keep if you leave the company. Your own contributions generally belong to you, while employer contributions can be subject to the plan's vesting schedule.
If you are struggling to pay for housing, food, transportation, utilities, or other basic needs, putting a large portion of your paycheck into retirement may not be realistic. The same applies when high-interest debt is consuming your income.
Sometimes the first step toward retirement savings is simply learning what your employer offers. You might not be ready to contribute much right now. You might start with a small amount and increase it later when your financial situation changes.
What Is Your 401(k) Actually Invested In?
Here's a detail that surprises a lot of new employees: putting money into a 401(k) does not necessarily mean the money is automatically invested in whatever option is best for you.
A 401(k) is the account.
The investments are what you choose to hold inside the account.
Most plans offer mutual funds, index funds, bond funds, stock funds, target-date funds, or other investment options. So, in a sense, a 401k is like an account where your money is put towards stocks or funds that build money while it sits. It also means, however, that the investment is subject to the fluctuations of the market with how much return you get.
A target-date fund is one option commonly available in workplace plans. You select a fund associated with an approximate retirement year, such as 2055 or 2060, and the fund is designed to adjust its investment mix as that target date approaches.
Your employer's plan determines which investments are available, so two people working for different companies may have completely different choices.
Take some time to read the information provided by your retirement plan. Look at the investment options, fees, and explanations the plan provides. If you do not understand what an investment is, that is a reason to learn more before putting money into it.
You do not need to know everything about investing before opening a 401(k). You do need to know where your money is going.
What Happens When You Leave Your Job?
Changing jobs does not make your 401(k) disappear.
Depending on the circumstances and the plans involved, you may be able to leave the money in your former employer's plan, move it into your new employer's 401(k), roll it into an IRA, or take the money out.
An IRA (Individual Retirement Account) is a retirement savings account that you open yourself, rather than one provided through your employer.
The rules and available options can depend on the specific plan and your circumstances.
Cashing out can be tempting, especially if you are between jobs and looking at a retirement account with several thousand dollars sitting in it. However, taking retirement money out early can result in taxes and penalties, and you also lose the opportunity for that money to remain invested for future growth.
For example, someone who changes jobs at 30 could look at a $5,000 balance and think, "It's only $5,000." That same $5,000 could potentially remain invested for decades, accumulating thousands more over time. What looks like a small amount today can represent part of a much larger retirement balance later.
If you leave a job, slow down before requesting a withdrawal. Find out what your options are and understand the tax consequences before deciding what to do with the account.
Final Thoughts
A 401(k) can seem complicated when you first encounter it, especially when your benefits paperwork starts throwing around terms like traditional contributions, Roth contributions, matching, vesting, investments, and target-date funds.
At its core, the concept is fairly straightforward: your employer provides a retirement account, money from your paycheck can go into it, and that money can be invested for your future.
How much you contribute depends on your own financial situation. Starting small is an option. Increasing your contribution later is an option. Learning how the account works before you contribute anything is an option too.
Understanding your workplace retirement plan puts you in a better position to recognize opportunities when they are available.
Up Next: One of the biggest opportunities that may come with a workplace 401(k) is an employer match. If your employer says it will "match" part of your contribution, what does that actually mean for your paycheck and retirement savings? In the next article, we will break down Employer Matching: How It Works and walk through the numbers with real examples.
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