What exactly is a 401(k), and what do you need to think about when you sign up for one? Let’s break it down.
A 401(k) is an employer sponsored retirement savings plan that includes special tax advantages.
Some employers match a portion of their employees’ contributions. For example, an employer might offer a 5% dollar-for-dollar match. This means that for every dollar you contribute to your 401(k), your employer will also contribute one dollar, but the match is limited to 5% of your salary.
Think of this as “free money,” and we recommend you contribute at least the amount needed to receive your full employer match. In this example, keep in mind that if you decide to contribute more than that 5%, your employer won’t match the additional contribution.
Every 401 (k) plan is different, so the options available will depend on your specific plan.
Contributions to a traditional 401(k) are not taxed going in, so they can reduce your taxable income. Later on, withdrawals are taxed, including any earnings your contributions had.
Your employer may offer you the ability to make Roth 401(k) contributions. With a Roth 401(k), you pay taxes at the time you contribute, but you won’t be required to pay taxes again on your contributions or investment earnings when you make qualified withdrawals in retirement.
Some people borrow from their 401(k) for major purchases like a home or education. That may be allowed, but it comes with some significant downsides and risks including giving up potential earnings and potentially paying taxes and penalties if you default on payments.
So, it’s best to think of your 401(k) as a long-term investment account that’s meant to be used for retirement. —You should use other accounts for emergencies, or as a way to pay for other savings goals.
To learn more about how to take control of your financial future, check out the other videos in our Finance 101 series.
