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How Your 401(k) Works

How your 401(k) works

The 401(k) is a form of retirement plan that many employers allow their employees to invest in. Participating in a 401(k) is better than simply investing your money on your own because you can save on your taxes and because your employer likely offers matching 401(k) contributions, which boost your retirement savings. Here’s how your 401(k) works and how you benefit from it.

Putting Money in a 401(k)

When you sign up for your employer’s 401(k), you give your employer permission to take a set amount of money out of each paycheck you earn and to put it in a retirement account for you. A brokerage firm or other financial company oversees this account and gives you a choice of mutual funds to invest in. The government sets a maximum amount you’re allowed to contribute to a 401(k) each year. As the IRS states, in 2015 the limit is $18,000, and employees who are 50 years old or above by the end of the year may contribute another $6,000 on top of the usual limit if their plan allows catch-up contributions. These limits change slightly from year to year because the government adjusts them according to the inflation rate.

Matching Contributions

One of the main perks that go with participating in a 401(k) is that employers frequently offer matching contributions. This is money that your employer adds to your 401(k) on top of the money you contributed from your paycheck. It doesn’t come out of your wages; it’s a bonus. CNN Money explains that the employer matches funds according to a proportion that is usually between 50 cents and $1 for every $1 you put in your 401(k), up to a limit like three percent of your salary. The only catch is that matching contributions don’t belong to you right away. During the first few years you work for a company, the matching contributions are either gradually assigned to you or held until that period is up. So if you stop working for your employer after just a year or two, you stand to lose part or all of the matching contributions, depending on the plan’s terms.

Traditional 401(k) or Roth 401(k)

When it comes to taxes, how your 401(k) works depends on whether you have a traditional 401(k) or a Roth 401(k). With a traditional 401(k), your taxable income goes down by the amount of your 401(k) contribution, so you pay less in taxes now than you would if you didn’t make a contribution. You don’t pay taxes on the money you contribute until years later when you take it out of your 401(k) in your retirement. In contrast, you pay taxes on the money you contribute to a Roth 401(k) before you invest it. But you don’t pay taxes on the money when you withdraw it. These types of accounts also differ in that workers who hold traditional 401(k)s pay a 10-percent penalty for early withdrawals, with exceptions for certain hardships, but workers can withdraw early from a Roth 401(k) without paying penalties provided they’ve owned it for at least five years.

Whichever form of 401(k) you have, you want to invest in it as early as possible so your money has more time to grow. And in order to get the full benefit from your 401(k), invest enough to qualify for the complete amount your employer offers in matching contributions.

Image source: Pixabay

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