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)?