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The Most Important Financial Terms Everyone Should Know: 401(k)

We’ve all heard the term 401(k). We know it’s something through work and that we are supposed to be using them or saving with them, or something like that, right? I hope to clear up some of the confusion about what a 401(k) is in this post.

 

A 401(k) is a savings account specifically for retirement. 401(k)s first became available in 1978 and are the government’s answer to help people save for retirement since most companies have gotten rid of pensions. 401(k)s got their name because that is the subsection of the IRS Code that discusses the rules around this specific retirement savings plan. 401(k) accounts are sponsored and set up by companies for their employees and are the most common and popular type of retirement savings account in the U.S.

 

With a regular 401(k) plan, money is deducted from your paycheck before taxes are taken out. The money deducted from your paycheck is then added to your 401(k) account. Since these 401(k) contributions are taken out of your paycheck pre-tax, the income remaining on your paycheck (taxable income) is lower. When you have lower taxable income, you in turn decrease the total amount taxes you pay at the end of the year. Each 401(k) plan typically offers a few options for investing your money. These options include a variety of mutual funds made up of stocks, bonds, and money market funds. So the money from your paycheck gets sent directly to your 401(k) account and then invested at your discretion in one or more of funds you select. There is a limit to the amount you can deduct from your paycheck and contribute to your 401(k) plan each year. The employee contribution limit for 2017 is $18,000, and this amount may change from year to year.

 

Why You Need to Know This

Not only can you reduce your taxable income and pay less taxes by contributing part of your paycheck to a 401(k), but many companies will match a portion of the money you contribute. This is literally free money from your employer, and you should not pass it up. Even if matching contributions aren’t offered at your company, you should still use contribute to your 401(k) because automatically saving for retirement is one of the easiest and most important financial moves you can make to help make sure you will have money when you are ready to retire.

Does your company offer a 401(k) match? What percent of your salary are you currently contributing to your 401(k)?

10 thoughts on “The Most Important Financial Terms Everyone Should Know: 401(k)

  1. Great post! Many people think I will get less in my pocket after 401k is deducted but it is actually going into your “future” pocket when you will need it because you won’t be working. I hope to contribute the maximum amount in the next year or two and was inspired to do so after reading so many articles that say 401k maximization is the first step towards savings goals. Thanks for the insight.

    1. Right on man! 2016 was the 2nd year I was to max out my 401k contributions. It is fun to watch how quickly the account balances grow, especially with that nice market jump last month! When income allows be sure to consider an IRA and even an HSA. They are both great accounts that can be used in retirement!

  2. This is the 2nd year I’ve met the maximum allowed contribution limit the government has set. This is the first year my wife has done the same (she was very close last year). I would recommend that anyone coming out of college with a good job (40k/year or better) set their contribution limit to reach 18k. At least TRY to survive on what’s left and figure your budget to allow for this. If it can’t be done (you probably don’t need that new car or fancy 2 bedroom apartment for yourself) then back it off as little as possible and raise it back up the following year. The minimum goal should be to reach that 18k contribution by year 5 (ideally year 1, but I understand not everyone is fiscally responsible). This should get you to your retirement goals much sooner than you expect (I wish I would have done this year 1).

    After you get to 18k … it’s time to start thinking of the next retirement account you can start to automatically take out of your paycheck (likely post tax) … and start increasing that contribution % yearly as well!!!

    1. You and you’re wife are doing great! I couldn’t agree more about wishing I saved more when I was just out of school rather than blowing money on junk I don’t even remember now. I really like the 401(k) automatic deductions because if I never see the money I never miss it. And then later in the fall after my 401(k) is maxed out it is nice to get those bigger surprise paychecks that can go towards funding, IRA’s, HSA’s, 529’s, and brokerage accounts like you suggested.

      1. If you do max out before the end of the year, make sure your company continues to “match” their percentage. I’ve read some companies look at the last few months and see $0 coming out of your check and their matching isn’t automatically done, so they have to actively go back and do a “true up” which in my case happens after the 1st of the year. I’m not sure all companies do this “true up” so you may need to make sure that 18k is getting contributed during the last pay cycle (if possible). Would hate for someone to lose out on that “free money”. This set up isn’t ideal because you’re losing the “value increase potential” of your companies matching dollars for a few months as well. But as long as they’re getting it right, it’s not that big of a deal in the grand scheme of things. I’ve decided to back off my contribution % each year just to make sure I’m hitting 18k in December and not in August for this reason. That keeps me diligent in contributing to those other funds (529’s, brokerage accounts) throughout the year though … every 1% removed from 401k contribution needs to be added to something else!!!

  3. Yeah really good point. I checked into that the first year I hit the max to make sure I was still getting the company contributions, which I was. That is a really good point for others though as all companies likely do things a little but different.

  4. I contribute 4% to my 401(k) and my company match is 4%. After my bonus hits in February, I’m going to bump it up to 10% for the rest of the year. If I can contribute 5-10k per year into my 401k and get a company match, I’m pretty happy.

    I invest in real estate on the side and want to have cash ready for any purchases that could occur there. Otherwise, I would definitely go the full 18k per year.

    1. The most important thing is that you ARE getting your free money from company match. That will always be the investment with the greatest return. And it sounds like you have a good plan for growing your wealth. Just keep pushing what you think is possible (both savings as well as REI) and I am sure you will find a way to accomplish more and more each and every year.

      I currently have one rental house and would like to get at least one more this year so I can understand wanting to have money on hand for a down payment on a rental property. Can you share if you usually just put down 20% and finance the rest or do you pay cash and try to refi later to pull out your equity for the next property? I am contemplating which approach I want to take with the next house I purchase. Thoughts?

What do you think?