What is a 401(k)?

A 401(k) is a type of workplace retirement savings plan that allows employees to contribute a portion of their income with pre-tax dollars into their own retirement investment account.  Although 401(k)s are the most commonly offered retirement savings plan amongst U.S. employers today, there are many variations such as 403(b), 457, and 401(a) plans that offer similar features and benefits.

How do 401(k)s work?

401(k) contributions are automatically deducted from your paycheck and invested in the plan. Meaning, contributions will come out of your paycheck each pay period unless you choose to stop contributing. In addition to being an easy and convenient way to save, 401(k)s can offer a number of other benefits that may make them an effective way for you to financially prepare for retirement.

Company Match

Sometimes, companies make matching contributions to help your account grow more quickly. For example, a company may contribute 50 cents for every dollar you contribute up to 6% of pay. In this case, if you contribute 6% of pay, then add the company match to your contribution, your contribution amount is effectively increased to 9%.

Compounding

Compounding is when the value of an investment increases because the earnings on your contributions are reinvested and, in turn, may produce even more earnings as time passes. Exponential growth occurs because the total growth of an investment along with the original contribution amount earns money – and keeps doing so over time.

Contributions can add up

The above chart assumes a hypothetical 6% annual compound return on contributions. There can be no assurance that any particular rate of return will be achieved.

Control

Most 401(k)s offer a variety of investment options. You have the opportunity to invest your money in options consistent with your risk tolerance and time-horizon. If you’re not sure of your risk tolerance, use our Asset Allocation Questionnaire to learn more about your investing style.

Tax Advantages

Contributions are deducted from your paycheck on a pre-tax basis, which means whatever you contribute reduces your current taxable income. When you eventually make withdrawals during retirement, you’ll have to pay taxes on original contributions and the account’s earnings at your ordinary income-tax rate.

Some employers may also allow you to make Roth 401(k) contributions. Unlike traditional retirement plan deferrals, contributions are made after-tax and withdrawals during retirement are income tax-free. And, unlike Roth IRAs, there are no income restrictions, so anyone can contribute.

If you are under age 50, you can put up to $18,500 in your 401(k) each year. If you are over age 50, you can put in an additional $6,000 each year – called a “catch-up contribution”. To see how your own paycheck may be impacted by contributing to a 401(k), use our Paycheck Analyzer Calculator.

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