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5 Things to Know About Your 401(k) — Like What Exactly Is a 401(k)?

401(k) nest egg
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Be honest: Do you really know what a 401(k) is? Because a lot of people don’t—even people who have one.

Okay, so we all kind of know what a 401(k) is. It’s retirement money. But beyond that, what actually is a 401(k)? These aren’t the things we discuss with our parents around the dinner table before we’re thrust out into the working world.

What started out in 1978 as a way to encourage more Americans to save for retirement has turned into an expected part of an employment salary-and-benefits package and could end up making a huge difference in your quality of life when you retire.

If you ever want to stop working and spend your golden years not punching a clock, you should know what a 401(k) is and how to participate if you have the chance.

Why Is It Called a 401(k)?

The 401(k) is named for the part of the tax code that governs it. Employer/employee retirement savings accounts are defined in section 401(k) of the Internal Revenue Code. Neither Congress nor investment bankers are extremely creative, so your employer-based retirement savings account is a 401(k). There are also other accounts—named for their sections of the tax code—that cover different types of jobs. A 401(k) is for employees of public or private, for-profit companies. People who work for nonprofit or tax-exempt employers contribute to a 403(b). State and local government employees contribute to a 457 plan. And federally employed civilians and members of the uniformed services make their retirement contributions to Thrift Savings Plans—the more creative name being the exception that proves the boring-name rule.

Why Should I Invest in a 401(k)?

The simplest and most compelling reason to invest in your employer’s 401(k) is that it’s free money. Basically, you get free money from the government in the form of pre-tax and non-taxed dollars and free money from your employer if they match your contributions. The beauty of a 401(k) is that your contribution is taken from your salary before taxes are deducted.

The benefit of this is that you will most likely be paying a lower tax rate when you’re retired and taking the money out of your 401(k). Basically, when you pay taxes on that money, you will pay a lower rate. Also, most employers will match an employee’s contributions to his 401(k) up to a certain amount. This means that you’ll actually get more money out of your job, on top of your salary. So, if you contribute 3 percent of your salary, your employer is also giving you the same amount in extra contributions. And don’t forget, it’s pre-tax extra money.

How Much Should I Contribute to My 401(k)?

You should contribute as much as you possibly can to your 401(k), especially if your employer is matching. Again, this is pre-tax money, so you’re effectively getting a pass from the government to squirrel away these funds and not let Uncle Sam take his cut until he can’t take as much from you. A standard employer match is usually 3 percent of your salary, although some will match up to 5 percent. For some people, an employer match can be a good negotiation point for a pay raise when a salary hike might not be an option.

Do keep in mind that you only have access to the funds your employer matches once you are fully vested. Being vested means that your employer has determined the amount of time you have to work for them to have access to the money they’ve put in your account. Once you’ve been there for that long, you are vested and can do what you want with the funds they’ve contributed. You always have access to the money you’ve contributed. If you can afford it, you should contribute as much money to your 401(k) as the tax code will allow. The more money you have in your 401(k) early on, the faster it will grow later.

What Are the Downsides to a 401(k)?

One downside of a 401(k) is that there is a limit to how much you can contribute in a year. Every year, the IRS sets the amount that can be contributed to a 401(k). In 2014, the maximum contribution is $17,500, the same as it was last year. And the total contributions to your account, including your employer match, cannot exceed 100 percent of your salary. People who are over the age of 50 are permitted to make a “catch up” contribution. The “catch up” limit is also determined every year. For 2014, the “catch up” limit remained the same as it has been since 2009: $5,500.

The other downside to a 401(k) is that you have to leave the money in the account until you are of retirement age. If you make a withdrawal before the age of 59-and-a-half, you will have to pay the IRS a 10 percent penalty. If you make a big enough withdrawal, that penalty can be quite severe. So, you can’t really consider it your money. You have to just let it sit until it’s time to start watching sunsets and telling stories to your grandkids.

What Happens If I Leave My Employer?

Probably the scariest thing about starting a 401(k) is the question of what will happen to the money you’ve saved if you quit or get laid off from work. But you have options, so this isn’t something that should prevent you from getting some of the free money your employer is offering while you’re there. If you find a new job, you can roll over your account balance to your new employer’s 401(k) plan. If you don’t get a 401(k) right away or you don’t have a new job right away, you can roll over your account balance into an Individual Retirement Account (IRA).

Some employers will allow you to leave your savings in their 401(k) plan even though neither of you is making contributions any more, although usually the account has to have more than $5,000 in it for it not to be an administrative burden. Or you can withdraw your balance in a lump sum and do whatever you want with it. This can be tempting in a sudden-job-loss situation, but you have to watch out for that 10 percent penalty and you have to keep in mind how difficult it is to make money when you are of retirement age. Just make sure you have the help of a financial adviser or accountant who can help you understand what your tax burden might be in either case.

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