The Complete Beginner’s Guide to 401(k) Plans

Since day one, I’ve been an advocate for people taking advantage of the 401(k) plans offered in their workplace. It is an incredibly useful tool for saving money for retirement. Without such savings (and without a pension plan, which is increasingly rare), when you retire, your only income will be from Social Security, which doesn’t offer a whole lot of money to live on and may not even be able to offer the same level of benefits in the future.

For many people, however, 401(k) plans are kind of scary. They involve having money taken right out of your paycheck, which means you’re going to bring home less money, and it’s often unclear where that money is going, plus signing up for the plan can seem complicated.  Today, it’s time to take the “scary” out of 401(k) plans.

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    What Is a 401(k)?

    In simplest terms, a 401(k) is an account – like a savings account – that you put money into for the purpose of having that money to use when you retire. You put money in now, it grows over time, and then you can take that money out in bits and pieces when you retire. That’s all it is.

    So, why do you need a special account for that? Why not just use a savings account?

    The reason is that a 401(k) account offers some very nice benefits when it comes to your income taxes. Everyone pays income taxes – it’s part of the reality of living in America. A 401(k) plan helps with taxes by deferring your income until later. The money you put into your 401(k) is not taxed right now. That means if you contribute to a 401(k) this year, you’re going to pay less in income taxes this year.

    Let’s look at a specific example. Let’s say you make $40,000 a year and you’re single. This income tax calculator estimates that you’ll pay in $4,594 in federal income taxes this year.

    Now, let’s say that you contribute 10% of your income to your 401(k), adding up to $4,000 a year. Now, instead of calculating your taxes based on $40,000 of income, you subtract out the money you contributed to the 401(k). You only pay income taxes on $36,000. Now, according to that same calculator, you’re only going to pay $3,994 in federal income taxes. That’s $600 less you’re spending in taxes, or $600 more that’s staying in your pocket this year!

    In other words, when you contribute money to your 401(k), your actual paycheck goes down less than the amount you’re contributing. In the example above, you’re contributing $4,000 over the course of a year, but your take-home pay is only going down $3,400 (the $4,000 you contributed minus the $600 you saved in lower taxes).

    A savings account, by comparison, doesn’t work like that. If you earn interest this year, you’re going to pay taxes on that interest this year. There’s no tax help with a savings account.

    There is a catch, of course. You will have to pay taxes on that 401(k) money when you take it out in retirement. However, when you’re retired, you’ll very likely have a lower overall income than you have now, so you’ll pay less taxes on it then than you would pay right now (because higher income means higher tax rates).

    What’s a 403(b), Then? What About a 457(b)?

    For you, there’s basically no difference between the two. The actual difference between the two is the type of employer you have. For-profit companies use a 401(k) plan, while non-profit companies use a 403(b) plan. Governmental agencies use a 457(b) plan, which is again almost identical to the other two. For pretty much all purposes, they function the same for the employee who might be putting money into that plan.

    From here on out, I’m going to use the term 401(k) to refer to all of these plans.

    Why Are They Called 401(k) or 403(b) or 457(b)?

    That number is actually a reference to the specific laws that govern those plans. The numbers refer to specific subsections in the Internal Revenue Code, which is the collection of tax laws affecting American citizens. You can think of the Internal Revenue Code as a giant book, and the laws describing the 401(k) plan are in Chapter 401 and in section (k) of that chapter.

    What Happens to My Money When I Contribute to a 401(k)?

    As I mentioned in the introduction, a 401(k) plan is a lot like a savings account. You put money into that account and you withdraw it at a later date after it’s (hopefully) earned some money for you.

    The big difference with a 401(k) plan as compared to a savings account is that once you put in the money, you’re given a bunch of options as to what you want the company that runs your 401(k) plan to do with that money.

    With a normal savings account, that’s not really an option. The bank chooses what to do with your money and pays you a pretty small but constant interest rate on the money while it’s there. So, with a savings account, the value will go up constantly, but slowly.

    In a 401(k), you actually have a lot of options as to what you want them to do with your money. Do you want them to keep it very safe and earn just a small but steady return, which is a lot like a savings account? Do you want them to invest it in things that have more volatility and risk, like stocks or real estate? Do you want something of a middle ground, which is what bonds are often used for? Or do you want a mix of all of these things?

    This is the part of signing up for a 401(k) that can feel overwhelming. There are usually a lot of options available. You don’t fully understand some of the options. You’re also really unsure about risk and the thought of losing a lot of the money you’ve saved seems scary… but at the same time, the lower risk options don’t earn very much.

    Understanding the Stock Market

    Here’s the thing – there’s already a pretty good answer for this problem. The further you are away from retirement, the more risk you can handle because you have time to recover from the big drops.

    Imagine a riskier investment like the stock market as being like waves on the beach during a fast-rising tide. Each wave is getting higher and higher on the beach, but between waves, the water retreats. That’s actually much like the ups and downs of the stock market. The stock market goes upward at a pretty nice rate most of the time – that’s like a big wave hitting the beach. But sometimes it retreats from its high-water point – that’s like the water retreating after a wave, but since the tide is rising really fast, it doesn’t retreat all that far.

    Now, if you’re just in the water for a little bit and you run out, the water might actually be lower than when you went in if you jumped in in the middle of a wave and then ran out when the water retreated, right? Or it might not be much higher if you ran in between waves, let a wave hit you, and then ran out. That’s why a short-term investment in the stock market is a bad idea. A “wave” in the stock market takes about eight years or so.

    On the other hand, let’s say you stand in the water for two or three waves. No matter when you get in or when you get out, the water is going to be much higher than when you started, even if you jumped in when there was a wave and ran out when the water was retreating from a much higher wave. That’s what a long-term investment in stocks is like. The water is going to go up no matter what if you stay in for a while – and it’s going to go up quite a lot.

    So, if you have a long time to wait until retirement – three or four big waves, in other words – you should heavily invest in stocks. As time goes on, your investment should slide more toward lower risk things (because there are fewer “waves” between then and retirement).

    So, how do you do that?

    Target Retirement Funds

    The easiest way I know of doing this is through target-date retirement funds. Most 401(k) plans offer these as an investment option.

    Here’s how they work. Target-date retirement funds are actually just a mix of a whole lot of investments. They contain some stocks, some bonds, some real estate, and even some cash (earning money much like an ordinary savings account). Some funds include other things as well – international stocks, precious metals, and so on.

    When you’re far away from retirement, a target retirement fund contains mostly stocks. However, as you slowly get closer and closer to retirement over time, the contents of that fund shift to a gradually less-risky mix of assets. It slowly begins to contain more bonds, more real estate, and, eventually, more cash.

    By the time you retire, that fund is going to mostly contain safe and secure investments so that you’re not as affected by the ups and downs of the stock market.

    If you’re not sure what investment option to select in your 401(k) plan, I highly recommend choosing a target-date retirement fund. Such funds are offered with different target “years,” such as Target Retirement Fund 2046 or Target Retirement Fund 2051. You’ll want to choose the one with a year that’s closest to your retirement year. To be safe, I’d suggest choosing the fund with a year closest to when you’ll turn 70.

    So, let’s say you’re going to turn 40 in 2017. That means you’ll turn 70 in 2047, so you should choose a Target Retirement 2046 fund (because that will probably be the closest one to 2047).

    Contribute all of your retirement savings into that fund for now. Remember, if you decide later on to make changes, you can switch the money around within your 401(k) without much trouble at all. There are no real tax implications for you in doing this, since all of the taxes are being deferred until your retirement.

    What Is a Roth 401(k)?

    Some of you may have an option in your workplace to sign up for a Roth 401(k) plan. In most respects, it works exactly like a normal 401(k) plan – you put money in, you choose an investment, you withdraw money at retirement, just like a normal 401(k).

    There’s one big difference, though. Instead of contributing money that you don’t have to pay taxes on right now, as described above, you contribute money that you do pay taxes on. In other words, if you contribute $4,000 a year as I described in the example above, your pay will actually go down by $4,000, not $3,400.

    So, why would you do that? The reason is that when you’re retired and you want to take money out of your Roth 401(k), you won’t owe any taxes on what you withdraw. All of it is tax free. With a normal 401(k), you’ll have to pay taxes when you take money out when you retire.

    Which one is better? It’s really hard to say because it depends on what happens with tax laws over the next 30 years and, honestly, no one knows that. My feeling is that, with a glut of boomers retiring, tax rates will probably go up at least a little in the next couple of decades, so a Roth 401(k) is a good deal in that respect. However, at the same time, many people are earning less in retirement than they earn during their professional years, so the Roth 401(k) is worse in that respect.

    In the end, I feel a Roth 401(k) is a better deal if you feel that your salary is relatively low right now, and a normal 401(k) is better if you feel that your salary is relatively high. Neither one is a bad choice, however.

    What If a 401(k) Isn’t Available To Me?

    In that case, you can set up a similar program on your own with the investment firm of your choice by opening an individual retirement account (IRA). It works in much the same way as a 401(k) does – you put money into the account, it grows, you withdraw it in retirement.

    However, instead of the money coming out of your paycheck, it comes out of your checking account. If you don’t have a retirement plan at work (or even if you do and your income is reasonably low), you can deduct all of your contributions when you file your income taxes. This can make it very similar to a 401(k) for people who already have deductions, like a family paying down a home mortgage. However, as with a normal 401(k), you’ll pay taxes on the money that you withdraw from the account in retirement.

    IRAs are available in both traditional and Roth forms. If you opt for the Roth IRA, your contributions aren’t tax deductible at all, but the money you take out is tax free.

    401(k) Matching Funds

    Some employers offer matching funds for employees who contribute to the company’s 401(k) plan. If your employer does this, you need to get on board right away because you’re essentially leaving part of your salary on the table if you don’t.

    Let’s say your employer matches 100% of your contributions up to 10% of your income, which is a fairly typical match. That means if you put 10% of your salary into your 401(k), your employer will also put 10% of your salary into your 401(k) above and beyond your normal income.

    For example, let’s say you’re making $40,000 a year and you decide to contribute 10% of your salary to get that match. You start contributing $4,000 to your 401(k) plan. That means, as described earlier, your pay only goes down by $3,400.

    However, your employer also drops another $4,000 a year into your plan. Yes, you’d be getting a $4,000 bonus that goes into your retirement fund. You’re putting $8,000 a year into your retirement savings and it’s only costing you $3,400 in terms of your paycheck.

    You will never get a deal like that in almost any other avenue in life. If your employer offers matching funds for your retirement plan, you need to sign up as soon as possible and contribute enough to get every dime of that free money.

    If you don’t do that, you’re flat out saying “no, you keep it” to your employer regarding part of your salary. That’s what it means to not take part in retirement matching.

    How Will I Withdraw Money When I Retire?

    When you retire (typically in your 60s or 70s), you can begin withdrawing money from your 401(k) plan. Usually, you can arrange things with the company that manages your 401(k) to receive your withdrawals much like a paycheck – you’ll just get a check in the mail or a direct deposit every other week or every month, depending on your wishes. They’ll often handle taxes for you as well, so it will be much like a normal paycheck.

    Most of the time, people note the value of their 401(k) on the day of their retirement and then withdraw around 4% of that value each year. So, if you had $100,000 in there, you’d be able to withdraw $4,000 a year. If you had $1 million in there, you’d be able to withdraw $40,000 a year. (Remember, this money is in addition to any income you get from Social Security.)

    Why 4%? The assumption is that your investments will continue to grow while you’re retired. A 4% withdrawal rate means that your money should last you for at least 30 years, according to most studies. If you want it to last even longer, you can go for a lower withdrawal rate. At 3%, for example, you could live a good 50 years and still have money in the account.

    In other words, when you retire, your 401(k) plan will essentially start issuing you paychecks if you so choose. (You can also choose to make a lump withdrawal if you’d like or a combination of the two.)

    What If I Need That Money Before I Retire?

    This is a truly horrible idea. You should only touch your retirement money as an absolute last resort, when you’ve exhausted every other possible route, because once you’ve drained your 401(k), you’ve reduced your options for the last 30 years of your life. There’s also a rather large 10% additional tax penalty against all early withdrawals.

    There are some limited situations where you can borrow against a 401(k), but you’re required to pay it back and it can get very difficult if you lose that job. It’s generally a poor idea to even borrow against that money, though it is possible.

    In the end, you’re far better off looking at the money in your 401(k) as untouchable until you retire. That’s the purpose of that money – to provide a good retirement for you. Tapping it early just takes away from that retirement and is often fraught with penalties on top of that.

    Trent Hamm

    Founder & Columnist

    Trent Hamm founded The Simple Dollar in 2006 and still writes a daily column on personal finance. He’s the author of three books published by Simon & Schuster and Financial Times Press, has contributed to Business Insider, US News & World Report, Yahoo Finance, and Lifehacker, and his financial advice has been featured in The New York Times, TIME, Forbes, The Guardian, and elsewhere.