What is a 401(k)?

This is an excerpt from my FREE REPORT: The Millennials and Gen Xers Guide to Getting Started With Investing and Choosing A Financial Advisor. You can get my report here.

What is a 401(k)?

When searching and sifting through copious amounts of confusing and conflicting information concerning financial retirement savings and plans it is quite likely that you have come across the term 401(k). You may have wondered if that was the newest robot in the Star Wars saga but the truth of the matter is that it is a type of retirement savings plans that is designed so that employees and employers alike can contribute to a fund that is set aside for your future retirement.

Many people invest pretax earnings into their 401(k) funds, which they then have the option to invest in mutual funds of many options. You will find these mutual funds in a wide array of choices from money market accounts to very aggressive and risky stock portfolios. If you work for one of the many companies across the country that offers the option of a 401(k) plan you would be literally robbing your future self not to take advantage of this offering.

There are 3 general types of contributions to 401(k) plans: matching contributions, elective contributions, and non-elective contributions. 

Matching contributions are very nice from the standpoint of the employee as the employer matches a predetermined amount of the funds invested by the employee towards this fund. Different companies will offer different amounts for their matching contributions. If your company will match up to a certain percentage of what you invest into your 401 (k) you should take them up on their offer. This is money that will benefit you later in life and should not be thrown away without a darn good reason for doing so.

An elective contribution is money that you invest before taxes are taken out of your salary. This means that you aren't paying income taxes on these funds at today's rate of taxation. Many people believe this is a good plan because the assumption is that you will be in a lower tax bracket upon retirement though there are no guarantees that that will be true. This money is money that you have elected to invest in your 401 (k) plan, rather than bring home in the form of salary, thus the name of elective contribution.

Non-elective contributions are funds that employers deposit into your account. In most cases, you cannot opt to take this money as cash rather than an investment in your 401 (k) plan.

There are limitations for how much you can invest into your 401 (k) plan in a given year. You should check with the IRS to get the actual numbers as they have changed over time and are likely to continue doing so as the cost of living increases across the country. Currently, you can contribute up to $18,000 in 2016. Once you reach the age of 50 you are allowed to make extra contributions to your plan in order to 'catch up' and better prepare for retirement up to $23,000 in 2016.

When studying your options for retirement financial planning you should carefully consider taking your employer up on any type of assistance they offer in this endeavor. If they offer to match the funds you invest in your retirement you can bet that money has already been deducted in their calculations of your salary. In other words, they are giving you the money you've earned in a different manner. The good news is that when the time comes to retire you will be able to appreciate every dollar that has been invested along the way. 

We could never hope to simply save the money that we will need in order to retire. Even investments are tricky for the vast majority of the population. For this reason, it is a wise investment plan to take advantage of any opportunity to increase your funds by employers matching your contributions. Take the maximum benefit they will match and if you are seriously worried about your financial future more than your current financial situations, invest the maximum allowable amount each year in your 401 (k) plan.

A good rule of thumb is saving 15% of your gross income before taxes if you're starting younger than 35. If you're 45, your goal should be closer to 20-25%. If these seem like extreme numbers, start with getting the match, then increase your contribution by half of your raise (if you get one). To elaborate, for example, say you can only do 5% right now. And say, you get a 4% raise each year. Each year, after you get your raise, increase your contribution by 2% until you hit your goal. If you work for a Fortune 500 company, many of their 401(k) plans allow you to set this up automatically. When you're enrolling for your benefits, I recommend setting this up at the beginning so you don't forget. 

What questions do you have?