What is a 401k?
401k take their name’s from a section in the United States Internal Revenue Code. A 401k plan is a taxed advantaged retirement account that is offered by many employers to their employees. The money that is put into a 401k plan is generally not taxed until it is taken out of the account. This also helps lower your taxable income on your paycheck.
How it works
When participating in a 401k plan, employees make a contribution to the account each pay period. Generally, this contribution is a set percentage of the employee’s income. For example: If an employee contributes three percent to their 401k plan three percent of the employee’s pay will directly be deposited into the 401k account pretax. In some cases, many employers will match their employee’s contributions up to a certain amount!
What is Matching?
Matching is when the employer will match the employee’s contribution to a 401k plan. The employer will cap their matched contribution at a certain percentage. While an employee can contribute more than the cutoff an employee will only match to the set percentage. For example: if an employee contributes ten percent of his income to the 401k plan but the employer will only match up to five percent they will receive the match for up to the five percent but not for the remainder. If an employer offers to match it is always wise to contribute ATLEAST to max they’ll match. It is literally free money that is additional to what they pay you in wages. All money that is contributed by the employee is theirs’ automatically but the employer’s contribution isn’t completely the employees until they are fully vested.
What does it mean to be vested?
To be fully vested is to have full ownership of the 401k account. To become fully vested, an employee will have to have worked for the company for a set amount of time. This is used as a retention tool to keep employees with a company for as long as possible. It is also possible to be partially vested. If it takes 5 years to be completely vested but you leave after two and a half years then you are only 50% vested. This means while you will receive the entire amount you contributed, you will only be able to receive half of the money that the employer contributed to the account.
Having a 401k can be very beneficial to you long term. Making contributions to your 401k can lower your taxable income which can help keep you in a lower tax bracket. Just like with a normal savings account or a CD you can borrow against it if need be. While it is not wise to withdraw from your 401k early it is easy to leverage it to get loans with low APRs. If you use it correctly it can be a valuable tool to prepare you for retirement especially if the company you work for offers to match. As a long term savings plan 401ks have a lot to offer.