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Demystifying Finance: What is a 401(k)?

Filed under: Budgeting, Family Finance, Investments, Saving
Tags: , , , — Written by: Simos
May 13, 2010
Retiremnt money

Retirement money
Photo by: Billy Alexander (Stock Exchange)

Every time there’s a dip in the stock market or a big company falls into dire straits, you can hear people fretting about three things: debt, the mortgage, and the value of their 401(k). For many, a 401(k) is a critical part of retirement savings. For others, especially young folk entering the workforce or professionals for whom retirement is a long way away, the 401(k) is something else entirely: a mystery, off in the unforeseeable realm of the future.

But, as with any long-term savings goal, the sooner you start saving for retirement, the sooner you can plan to enjoy it. Since retirement can mean many years of your life – and there’s just no telling what kind of Social Security protections or other government programs will be healthy twenty, thirty, or forty years down the line – it’s important to start thinking about it now. So we begin with an introduction: just what is a 401(k)?

The 401(k) and You

Put simply, a 401(k) is a kind of savings plan that allows you to put money aside for retirement and protect that savings and its interest from taxation until you’re ready to use it. Until a worker reaches the age of 59.5 or is ready to leave company service for retirement, there are serious restrictions on withdrawing any funds from the plan. In practice, this is because companies, through a third-party plan administrator, are engaged in investing the value of employees’ 401(k) plans, and (hopefully) growing them.

Pros of the 401(k)

Though the amount of money an employee can contribute to their plan is capped at a certain percentage of their wages, every dollar you contribute reduces your taxable income and lowers your tax burden. Because no taxes are taken “off the top” of your contributions, your investment can start to accrue more interest sooner. And in many cases, companies will match your contribution on a percentage basis, chipping in a quarter or more for every dollar you add. That is a big deal, and compares favorably to investment opportunities that are taxed before the money starts really working for you.

Cons of the 401(k)

Over three-fourths of companies with 100 or more full-time employees offer a 401(k), but it still may not be the right investment tool for you. Because of stiff penalties against withdrawing from your 401(k), don’t expect to use the earnings to pay bills or reduce credit card balances, even if unforeseen circumstances require emergency spending. Further, and most frightening, 401(k) money can be endangered in a number of ways: if it’s heavily invested in the stock market, for example, it’s subject to the same risk as other non-diversified investments.

Conclusion

Overall, a 401(k) is a very strong long-term investment if backed by a reasonable rate of contribution matching from your employer. Lately, though, many major firms that used to provide strong matching have backed down in an effort to curb expenses. This can have a huge impact on your 401(k)’s earning potential over time, but there are still steps you can take to ensure a healthy fund for retirement. We’ll discuss more in a future post.

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