What is a 401k?

If you aren’t yet saving up for retirement, you could be doing yourself a disservice. That’s particularly true if your employer offers a 401k plan and you haven’t taken advantage of it because you’re not sure what it is or how it works.

The Basics

401k plans are named for the subsection of the tax code that made such accounts available to the public during the 1980s. The money placed in 401k accounts is invested in stocks, bonds, and mutual funds by a designated corporation. These businesses will occasionally let you know how your investments are doing. Most accounts are also set up so that they become more stable as the person who owns them reaches retirement age.

These savings accounts were initially offered by employers as a way for people to supplement their retiree pensions. However, as time went on pensions generally became obsolete and they were replaced with these sorts of retirement saving plans. There are now many companies that will match what their employees contribution to these accounts, even if it’s only up to a certain amount. This can pay off greatly in the future and you should definitely sign up for the program if your employer offers it.

The Benefits

Storing your extra income in a 401k account is a good way to lower your income taxes. This practice is also a good way to keep the government from taking a hefty percentage of your salary. The money that goes to your account and any monetary gains aren’t taxable as long as they stay there. The government is only interested in funds that are removed and subsequently become part of your income.

What is Roth 401k?

There’s also a version called the Roth 401k. The main difference is that people with these accounts pay their taxes beforehand rather than after the fact. That way you don’t have to pay the government when you make a withdrawal because you have already done so. Another difference is that Roth 401ks allow users to take out their money without paying any penalties as long as the account has been around for at least 5 years.

The Drawbacks

Of course, you may have to work for a company for a certain amount of time before their contributions to your account become accessible and you can only put a certain amount of cash in your 401k every year. But perhaps the most annoying aspect of a traditional account is that there are penalties for taking money out before the government deems you old enough to retire.

There’s also the fact that 401k programs are not currently available for everyone. People who don’t have access to this sort of saving plan may want to consider setting up an individual retirement account (IRA) instead, but it’s not quite the same thing. After all, there are some people who choose to have both types of savings accounts.

Sources:
https://www.nerdwallet.com/blog/investing/what-is-a-401k/
http://guides.wsj.com/personal-finance/retirement/what-is-a-401k/
https://en.wikipedia.org/wiki/Money_market_fund

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