What is a 401k?

What is a 401K

At its most basic, a 401(k) is a savings tool offered by employers that allows an employee to get a tax benefit on the money they invest.  Most often this money is tax deferred, or put into the 401(k) by the employee before taxes are deducted, and then taxes are paid at the point the funds are withdrawn.  There are some plans called Roth 401(k)’s that allow for dollars to be invested after-tax, and which grow and can be withdrawn tax-free.  Individuals under the age of 50 can save up to $18,500 a year, while those age 50 and above have a higher cap of $24,500 to allow for make up payments in the event they did not save enough earlier in their career.

Employer Contributions

Not all employers do this, but they do in some cases make matching contributions up to some level of what the employee is investing.  If they do match, the most common practice is to match 50 cents for every dollar you invest, for the first 6% saved.  This can be a major perk for those employees who are responsible savers, and take advantage of these matching contributions especially early in their career when the money has a long time to grow in the market.

How is 401k Money Invested?

Most 401(k)s give you a mix of funds to select from which give you the ability to invest aggressively or more conservatively.  There are a lot of different 401(k)s out there, and while most offer good options, you do want to watch for funds that may be charging higher fees than normal.

This mix of funds will typically give you the ability to diversify the type of investments, such as healthcare, technology, or a fund that focuses on foreign investments.  Just as its wise to not tie all of your money into any one stock, giving a diversified look to your 401(k) portfolio is a good idea.

401(k) Penalties

There are very few downsides to investing in a 401(k), as the vast majority of people are able to see their money grow, and then take payouts during retirement when they are paying a lower tax rate.  The only potential issue that can arise is if you need that money prior to turning age 59-1/2, which is the age when you can withdraw penalty free.

If you find yourself in this situation, not only will yo need to pay income tax on the funds at your current rate, but you will in almost all circumstances need to pay an additional 10% penalty.  Therefore while it’s a very smart thing to invest in your 401(k), if for any reason you think you’ll need that money before reaching 59-1/2, you may want to be cautious.

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