In my last post, I explained how employees can designate part of their paychecks to a 401(k). Now, let’s dive deeper into what a 401(k) is and how it works.
What is a 401(k)?
401(k): A Company Retirement Account
It’s sponsored by either your employer (if you’re salaried) or by your own company (if you’re self-employed). You can’t open a 401(k) on your own; it must be set up through a company. Additionally, not all companies offer a 401(k), so it’s worth checking before accepting a job.
401(k) Money Comes From Your Paycheck
A 401(k) is a workplace plan where money is taken directly from your salary. You decide how much you want to save, and that portion is deducted from each paycheck and transferred to your 401(k) account. The more you contribute, the more you save for retirement.
Additional read: Understand your paycheck. What money is taken away from your paycheck.
Two 401(k) Options: Traditional & Roth
Traditional and Roth 401(k) plans have their own pros and cons, depending on what your employer offers.
Here are the differences:
| Airlines | 401(k) | Explained |
|---|---|---|
| Budget Airlines | Traditional 401(k) | Save upfront but pay extra later |
| Mainline Airlines | Roth 401(k) | Pay full upfront but avoid extra later |
- Traditional 401(k): No taxes on contributions, but you pay taxes on withdrawals in retirement.
- Roth 401(k): Taxes paid upfront on contributions, but no taxes on withdrawals in retirement.
Benefits of a 401(k)
Why take money out of your paycheck for retirement savings? Here are the key benefits:
Get Tax Breaks from IRS
401(k) vs. Brokerage Accounts: Brokerage accounts are taxed twice (when you deposit and withdraw). With a 401(k), you only pay taxes once.
| Account type | Tax when deposited | Tax when withdrawn |
|---|---|---|
| Brokerage | Take-home Pay (already taxed) | Pay tax again on earnings |
| Traditional 401k | No tax | Pay income tax |
| Roth 401k | Pay income tax | No tax |
Employer Match (Free Money)
Employers may match a percentage of your contributions, which is essentially free money. Always try to contribute at least enough to get the full employer match.
Here is a hypothetical example. Assume the annual salary is $50,000.
| 401k contributions | Employer Match |
|---|---|
| 5% | 3% match for 50% of your contributions |
| $50,000*5% = $2,500 | $50,000*3% = $1,500$1,500*50% = $750 |
Total saved will be
$2,500 (your contribution) + $750 (free money from the employer) = $3,250
* Note: Whether an employer match is offered depends on your employer.
Hassle free retirement savings
Your retirement money is automatically taken from each paycheck, so you don’t have to think about it.
Once you have cash in hand, it’s tough to save because spending on immediate needs is appealing. Retirement savings often get pushed to the bottom of the list.
A 401(k) makes saving for retirement easy. Once you’re enrolled (see the next section for how-to), a portion of your salary goes straight into your 401(k) account. This setup is great because it takes care of your savings with minimal effort, letting you focus on other things.
How does 401k work: How you can build your 401k step by step.
You’ve learned about the many benefits of a 401(k). Now, how do you get started and build your 401(k)? Here’s a step-by-step guide on what you need to do and when to do it.
Step 1
- When: New employee orientation
- What:
- (Auto) Enrolled 401k plan.
- Determine the contribution amount
- Determine the investment option
Step 2
- When: Pay period
- What: Ensure the predefined amount from your paycheck is deposited to 401k
Step 3
- When: Every 6 month
- What: Track your 401k balance & fees
Step 4
- When: Switch employer (End of employment)
- What: Track all final contributions for the fiscal year and understand how much you are still eligible to contribute to your new 401(k) account.
By following these steps, you can systematically build and manage your 401(k) to ensure you’re making the most of this valuable retirement savings tool.
