what is the definition of a 401k and how do they work

What Every New Employee Needs To Know About Their 401(k) Plan

Are you wondering “How do I open a 401k account?” Or are you starting a new job and looking through your new employee benefits package wondering what exactly is a 401(k) plan?

Investing for beginners can be confusing! Learn about everything you need to look for in a 401k plan and the advantages and disadvantages of having one!

Having a 401(k) is really one of the most important retirement tools that a person can have.  Unfortunately, many Americans do not take advantage of these and have far less saved for retirement than they ought to.

A recent survey discovered that 21% of Americans have nothing. Yes, I  repeat NOTHING saved for retirement- and only 1/3 of Americans have $5000 stashed away for their retirement. 

To put this into perspective only 31% of US adults could last a couple of months on the money they currently have saved if they were to retire tomorrow.

Read on to learn exactly what a 401(k) is and how you can guarantee you will be ready for retirement.

 What Is A 401k?

In simple terms, a 401(k) is a retirement plan.  If your employer offers a 401(k) plan it may be one of the easiest ways for you to save for retirement. Contributions to a 401(k) are automatically deducted from your paycheck each and every pay period.

The funds you invest into a 401(k) can be invested in stocks, bonds, mutual funds or a mix of all of the above.  The great thing is you aren’t taxed on any dividends or capital gains until you begin withdrawing the money which ideally wouldn’t happen until retirement.

The benefit to being taxed at withdrawal is that most people are in a lower tax bracket at this point in their life, which is good for you because this means more money in your pocket. 

401(k) plan

3 Benefits Of  Having A 401k

1. Employer Match Programs

One of the most beneficial components of a 401(k) plan is an employer match. If you are lucky enough to receive an employer match this is something you should most definitely take advantage of.

How Do Employer Match Program Work?

Employers will match your contribution up to a certain percentage of your salary.  Most employers typically match anywhere from 3% to 6 %, meaning your employer will contribute 3% to 6% of your salary as long as you are contributing that much. 

With a 6% contribution and a 6% match, you would essentially double your retirement savings.  YES! thats absolutely FREE money you should be taking advantage of immediately! 

Here’s an Example of  Jessi’s company matching the percentage of her contribution up to a limit

  • Jessi makes $40,000 and electe to contribute 6% of her annual salary to her 401k
  • Jessi’s company will match up to 50% of her contributions, which in this case is 3%
  • Jessi contributes $2,400 (6% of her salary)
  • Jessi’s employer contributes $1,200 (3% of her salary)

Cha-ching! Jessi just received $1,200 of FREE money from her employer for her retirement!


2. Tax Advantages

Contributions to your 401(k) can lower your taxable income allowing you to pay less money in taxes. This essentially works by your employer taking out money from your paycheck and putting it into your 401(k).

At the end of the year when you receive your W-2 you will notice that your taxable wages are lower because of your contributions to your 401(k) plan.

Sounds like a win right? It is except you can’t avoid the system completely.

For some, it is great to have your taxable income reduced upfront but you can’t ditch Uncle Sam altogether.  Eventually, the IRS will be taxing you.  So even though you were able to grow your money tax deferred-they will get you in the end when you begin making withdrawals. 

But remember as stated above this usually works out in your favor because your taxable income will most likely be less at this point in your life.

3. Portability

The great thing about a 401(k) is you don’t have to worry about changing employers because you can transfer it to a new account or roll it over into a retirement account you already have open.

What Should I Do With My 401k If I Quit?

1. Rollover

You can roll over the amount in your 401(k) into an individual retirement IRA.  Ding Ding Ding!! This to be the best option for most people. This allows you to keep an eye on all of your money in an IRA of your choice.

2. Leave It

You can simply leave your assets in your old employers 401(k) Retirement plan. This may not be the best idea if you think you will have difficulty in the future remembering where all of your assets and investments are.

3. Rollover To New Employer

You can roll over your old plan into your new employer’s 401(k) plan.  This may not work for everyone unless you already have a job lined up before leaving your current employer.

4. Cash out-Don’t do it! (Nope, Not an option)

Cashing out is not a good idea.  By cashing out you will not only pay a lot of money in taxes and penalties but you will miss out on the compounding effect of your money which can haunt you for years. 401(k) early withdrawals are just bad idea so do your best to avoid this situation at all costs.


401(k) Contribution Limits

If you are getting excited and want to begin paving your path to retirement you may be wondering what the maximum contributions are for your 401(k).

  • 2017 $18,000
  • 2018 $18,500
  • 2019 $19,000

As you can see the total maximum contribution limit has increased by approximately $500 a year however, this isn’t always the case.

The contribution limit is based on the cost of living so this will go up and down depending on the economy.

For those who are age 50 and older, you can contribute more because there is what is called the “catch-up” contribution which is currently (2018) limited at $6,000 a year.


401(k) Investment Options

There are many different options you are faced with when deciding where to invest your money.

The most common types of investments are blended funds or target date funds.  Target date funds hold a basket full of investments and strategically increase or decrease your risk in the market based on your planned retirement date.

How Do I Choose A 401(k) Plan?

When you are going through your new employee handbook it can be quite overwhelming trying to decide where to put your money. Most employer plans provide at least four options, each featuring different risks and returns. 

Money Markets

These are considered “safe” low-risk low return funds.  Money market funds are liquid investments that are often used as emergency cash funds due to the minimal risk.

Needless to say, I wouldn’t recommend money markets to anyone who is looking for longterm grown and has several years to ride some market waves.

Bonds/Income Funds

The goal of Income funds is to generate regular income for investors. These funds are good for those who are nearing retirement and are looking for a good way to cautiously make a little money by letting it grow while not losing what is invested.

Blended Funds Investments

These funds hold both stocks and bonds aiming to provide a good mix of profit and security.  These are geared towards investors who are looking for a mixture of safety, income, and capital growth.

Blended funds are popular because you get the growth of stock investments while having the safety of bonds to balance things out.  Stocks can be risky but younger investors have more years to invest so they are able to deal with a bit of volatility in the market because they have time to recover. 


Target Date Funds

A target-date fund is one that’s primary goal is to grow your money for a specified period of time.  

For example, if you have the goal of retiring in 2040 this is your “target date”. By nature, these funds decrease in risk tolerance and become more conservative as they approach your target date.  

For example, if you are years away from your retirement date your plan may invest heavily in stocks (risky) and less in bonds (safe) because you have years to invest before retirement.  As you become closer to your target date your plan will begin investing more in bonds and less in stocks to ensure you don’t lose your money right before you plan to retire.

These funds are the most hands-off approach requiring very little attention to invest, however, the fees with target-date funds tend to be a bit higher than others.


These are composed entirely of….. Guess! You guessed right, Stocks!  These generally, carry the greatest risk but also the greatest potential for returns. The objective of a stock fund is to seek long-term growth on your investment.  These funds are good for investors who are in it for the long haul and are aware of the risk factors.


What Is Maximizing your 401k And How Do I Do It?

It’s a good idea to check in on your investment portfolio from time to time. Think about it, you have several years to make your money work for you and no one wants to discover that they could have been doing something a bit different many years prior to help make the most of their money.

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    Pay Attention To Fees

    If I could recommend one thing it would be to pay attention to investment fees.  Many people spend years and years investing in retirement and are unaware of the fees they will be hit with when they decide to withdraw their money.  By knowing the fees you will have a better idea of the amount of money you will have at retirement.

    Did you know that by having high fees on your investment accounts it can significantly reduce the amount of money you will retire with and sacrifice many years of investing?

    In this research study it was discovered that only half of retirement plan participants even noticed that their fee information was disclosed within their paperwork, and only 7% took any action to actually learn how much they were paying in 401(k) fees. 

    Don’t be the person who works your rear off saving and investing only to have your money stripped away due to fees.

    How Much Should I Invest In My 401k?

    Seems like such an easy answer after we have covered everything we have.  However, if you are tight on cash and having a difficult time swallowing the thought of investing your money. 

    At least do the bare minimum amount to receive your employer match.  I say minimum because some people should really consider saving more.  As we have learned this is FREE money and is one of the easiest places to start with investing.

    Rebalance And Be In Charge

    Did you know that if your 401(k) isn’t managed properly you could end up having a conservative savings goal when you were hoping to be aggressive?

    Unfortunately, it happens all too often where people don’t have the right “basket” of stocks and bonds in their 401(k) accounts.  This can really affect your retirement goals.

    By being too conservative you may not have the amount of money you were hoping to have by retirement.  As mentioned above a younger investor has time working on their side so they are able to ride the waves of the market.  By riding the waves you are likely to receive better returns due to the years of investing.

    Final Thoughts

    Do you and your retirement a favor by beginning to invest in your 401(k).  If I scared you off when I mentioned that you should do your best to keep an eye on your investments don’t be scared.  This FREE tool is a fantastic portfolio management monitoring tool that can help you with the routine checkups. 

    As always if you have any questions don’t hesitate to send an email or write a comment below.

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    401(k) plans are a great retirement option you should be taking advantage of. Understanding 401(k) plans does not have to be confusing or even difficult. This guide breaks everything down for you in an easy to understand way that allows you to know what is happening with your money once you invest it. #investing #401(k)plans @fivesensesofliving.com
    401(k) plans are a great retirement option you should be taking advantage of. Understanding 401(k) plans does not have to be confusing or even difficult. This guide breaks everything down for you in an easy to understand way that allows you to know what is happening with your money once you invest it. #investing #401(k)plans @fivesensesofliving.com
    401(k) plans are a great retirement option you should be taking advantage of. Understanding 401(k) plans does not have to be confusing or even difficult. This guide breaks everything down for you in an easy to understand way that allows you to know what is happening with your money once you invest it. #investing #401(k)plans @fivesensesofliving.com
    401(k) plans are a great retirement option you should be taking advantage of. Understanding 401(k) plans does not have to be confusing or even difficult. This guide breaks everything down for you in an easy to understand way that allows you to know what is happening with your money once you invest it. #investing #401(k)plans @fivesensesofliving.com

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