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I’ve come across the term 401(k) many times, and although I’ve always known it’s related to saving money for your retirement, I’ve always wondered what the hell it actually is.
Is that how much money I should be aiming to save?! Is it a document? A savings account?
Well, today I actually looked it up:
The first google result defines a 401(k) as:
“A retirement savings plan sponsored by an employer. It lets workers save and invest a piece of their paycheck before taxes are taken out.“
They’re named after the section of the tax code that governs them – nothing to do with an amount of money.
Essentially, a 401(k) is the most common type of employer-sponsored retirement plans in the USA, allowing you to save money for your retirement without paying tax on the savings until you withdraw the money in retirement. This will generally mean you pay much less tax on your savings as your taxable income will be far lower in retirement age than it is when you’re contribution towards the plan.
FYI: 401(k)’s are an American thing – in the UK, it’s just a pension plan. I didn’t even need to be worrying about 401(k)’s at all! Doh! These are the things we should be learning in school, people!
However, I know my readers can come from anywhere, including America, so it’s not exactly fair to leave those of you the question actually applies to without a proper explanation.
How does a 401(k) work?
Money from your paycheck contributed to your 401(k) plan by your employer before taxation, and are limited to $18,000 per year. As the money is withdrawn before tax, your overall taxable income is lowered.
Your employer will typically also contribute to your 401(k) also, matching anywhere from 25 – 50% of the contributions you make. For this reason, your savings in your 401(k) can rise significantly in just a few years.
How do I get one?
Many employers offer a 401(k) as part of your contract, although you may have to wait a trial period before you are able to participate to ensure you don’t leave immediately after receiving contributions to your plan by your new employer.
What happens if I leave my job?
If you leave your current employer, don’t worry, you’re not going to lose all the money contributed to your plan. You can either roll your balance over to your new employer’s plan, put it into an Individual Retirement Account (IRA), or withdraw the whole amount as cash – although you will be heavily taxed in this last instance.
If you’re looking to save money to contribute to your 401(k), pension plan, or a simple savings account for rainy days, check out my step-by-step guide to establishing a monthly budget.
I hope this helps – the term is a definitely a lot clearer to me! If you think you are entitled to a 401(k) with your current employer, or are unsure about your own circumstances, I’d advise you either talk to Human Resources at your company, or speak to a financial adviser.