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What Is a 401(k)?

Work for a for-profit company? You may have access to an employer-sponsored retirement plan called a 401(k). Maybe you heard about the 401(k) option when you first joined the company but you haven’t taken advantage of it yet. Or maybe you’re wondering how you should use your 401(k) as part of your retirement planning. We’ve got you covered with our guide to the ins and outs of the 401(k) and what it can do for you.

Check out our 401(k) calculator.

Why a 401(k)?

The 401(k) hasn’t always been around. In the old days, many workers could count on a pension from their company. The idea was that the pension, combined with Social Security, would be enough for a dignified, though not lavish, retirement. Pensions are an example of what’s known as a defined benefit plan. The benefits a worker received were calculated according to a formula that took into account salary, age and time with the company. You could count on regular pensions checks in retirement, no matter how the market performed. But pensions were expensive for employers, and many companies gave up on them.

What replaced pensions? The defined contribution plan, of which the 401(k) is probably the most famous incarnation. The 401(k) began to take off in the early 1980’s. With a 401(k), it’s the employee who bears the risk of market fluctuations. The benefits of the worker’s retirement plans are not defined. They could be wiped out by the market, or the retired worker could outlive them.

With a 401(k), it’s on you to set up the plan, and to decide on a reasonable allocation between stocks, bonds and other holdings. Some people get 401(k) matches from their employers, which sweetens the deal considerably. If you’re lucky enough to have access to an employer match, it’s a usually a good idea to contribute enough to earn the maximum possible match.

How a 401(k) Works

Your employer decides on a handful of investment choices that you and your fellow employees will have. You select one of these options, usually a mutual fund. Ideally, you make an informed decision that takes into account your risk tolerance, age and how much you need to save for retirement.

Find out now: How much do I need to save for retirement?

You decide on a 401(k) provider and plan and then you decide what percentage of your paycheck you want to allocate to 401(k) contributions. Essentially, you say to your employer, “Go ahead. Take 15% of every paycheck and put it in that 401(k) account.”

By saving in a 401(k), you lower your taxable income, since your take-home pay is reduced by the amount you decide to contribute to your 401(k). That means lower taxes for you! But there’s a catch. When you start taking distributions from your 401(k) in retirement, the money you take out of your 401(k) is taxed just like regular income. Since most people are in a lower income tax bracket in retirement (because they’re no longer working and they don’t need as much money to live comfortably), a 401(k) often makes tax sense.

If, however, you think you’re going to be in a higher tax bracket in retirement, a Roth 401(k) might make more sense for you. With a Roth 401(k), you contribute after-tax income, but you don’t pay taxes on withdrawals in retirement.

Related Article: What to Do With Your 401(k) When Switching Jobs

How to Open a 401(k)

If your company offers a 401(k), someone probably told you about it when you joined. But in those busy first few weeks, when you were making friends and learning how to use the fancy coffee machine in the office kitchen, you may have neglected to actually enroll in your company-sponsored 401(k) plan.

That ends today. Or whenever you decide to take action. The exact procedure for opening a 401(k) varies from company to company. If you work in a large office, you may have an HR representative you can go to who will hold your hand through the process. If not, you may need to ask your supervisor or colleagues for a little help. You’ll have to decide what percentage of each paycheck you want to allocate to your 401(k). Our 401(k) calculator can help you pick the amount that’s right for you.

Bottom Line

If you haven’t yet set up your employer-sponsored retirement plan and you can afford to lose some money from your take-home pay, why not open a 401(k)? Provided, that is, that you have 401(k) options that offer low fees. Some companies have gotten into hot water by only offering high-fee investment options, and for neglecting to inform their employees about the impact of fees, which can eat into your retirement savings.

If your employer offers a match, it’s a good idea to contribute at least as much as you need to in order to get the maximum in matching funds. So, if your employer will match contributions of up to 6% of your salary, consider contributing at least 6%. If you want to contribute over and above that amount, great, but there are also other options for your retirement savings. The important thing is to start saving.

Photo credit: flickr

Amelia Josephson Amelia Josephson is a writer passionate about covering financial literacy topics. Her areas of expertise include retirement and home buying. Amelia's work has appeared across the web, including on AOL, CBS News and The Simple Dollar. She holds degrees from Columbia and Oxford. Originally from Alaska, Amelia now calls Brooklyn home.
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