What is a 401k?
“Why aren’t you signed up for the company’s 401k?”
“Oh, I’d never be able to run that far…”
Not bad as far as finance jokes go. But kidding aside, what exactly is a 401k and why on Earth is that the name?
The actual history behind the 401k is something we’ll get into with another post. But the name comes from our lengthy, wordy, largely impossible to comprehend, tax code. Section 401-K, to be exact. See what they did there?
The 401k is a plan that allows employees to save and invest with money they are paid before income taxes are taken out. Since the money is deposited directly through payroll before the employee actually receives it, it is not seen as income and therefore, it is not taxed at this time.
Choosing to have a portion of your pay contributed directly to your 401k at work effectively reduces the amount of income the IRS comes asking for a chunk of each year. But there’s more…
The money you save and invest in your 401k also grows without concern for taxes until you take the money out, ideally not until retirement. This is where the term tax-deferred comes from.
Roth 401k Contributions
Your employer may also offer what is called Roth 401k contributions. This is a term used to describe money that is contributed directly to the 401k, but after taxes are taken from your paycheck. By choosing roth contributions, you are paying taxes today so that you don’t have to pay taxes at all on that money, or the growth of that money, in retirement.
Roth contributions allow the contributions to grow tax-free vs. tax-deferred. The downside is that roth 401k contributions do not reduce your taxable income like regular pre-tax contributions do. Figuring out which is best for you really depends on your own personal situation, but we generally recommend choosing some combination of both, if your plan allows.
The Icing on the 401-Kake
Reducing taxes. Deferring taxes. It’s all pretty great. But arguably the biggest benefit to the 401k is available in about half of all plans – the employer match. This is where your employer agrees to match a portion, typically dollar-for-dollar or 50 cents on the dollar, for every dollar you contribute, up to a certain limit. A common example would be a 50% match up to 4% of your salary.
So if you contribute 4% of every paycheck to your 401k, your employer kicks in another 2%. That’s free money folks. And an immediate 50% return on your investment. It truly doesn’t get much better than that. So as a general rule, if your employer offers one, take full advantage of the match, at the very least.
Click here to find out what the IRS will allow you to contribute to your 401k.
Managed 401K with Blooom
There are many reasons to allocate contributions to both a Roth & traditional 401k. Now that you know what a 401k is, know that Blooom is here to guide your way through the world of retirement savings. With Blooom in your corner, you can rest easy knowing we are with you every step of the 401k way. Check out our approach to managing your account or see how your 401k is doing with our free 401k analysis.