Heather K Adams
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Content + Copy Writer

What is a 401(k) plan, and how does it work? 

Basically a 401(k) plan is a savings account by way of investments made in stocks, bonds and other options offered to you through your employer. It's an account you build up specifically for retirement, which you can begin to access after a certain age (usually between 55 and about 60). Your employer will deduct a portion of your pay before taxes to be put into your account. You'll have a number of choices to make about your investment options, and your employer might even offer to match your contributions to the account up to a certain point. The amount you contribute to your 401(k) plan isn't part of your taxable income, and the interest from your investments won't be taxed either. You will pay taxes later when you take money out of the account but only on the amount you withdraw each time, not the total you have saved.

How to set up and manage your 401(k).

1. Make sure you've enrolled or opted into your employer's 401(k) plan.

Sometimes, this will be done for you by your employer, in which case you'll simply receive information on your account and any decisions you need to make for it, such as the amount (dollar or percentage) you want to set aside from each paycheck to pay into it and which investment options you want to put that money toward (more on that below). Other times, you'll have to submit all the enrollment paperwork yourself or even wait until a mandatory trial employment period has passed. If your company offers an employer match option, meaning they'll match what you pay into your account (within limits), you should make sure to meet their requirements for matching. It's important you know what a 401(k) plan is and how it works in order to make these and other decisions.

2. Consider getting help with managing your investment options.

The 401(k) plan your employer offers is likely to include a number of investment options and opportunities to choose from and manage, including mutual funds, stocks and bonds. You can choose to manage these investments actively, as you would any other stock portfolio, making sure all the money you're working so hard to save is working just as hard for you in the long run. But, of course, managing investments while also juggling the details of your plan's employer match requirements and potential fees — not mention avoiding any penalties — can be a bit overwhelming, especially if this is all still very new to you. Don't be afraid to consult with an investment specialist who can walk you through your options and help you know what will work best for you when it comes to making further investment decisions.

3. Understand all applicable fees and penalties.

It's important to be familiar with the nuts and bolts here, understanding what a 401(k) plan is and how it works, even if you don't plan on taking an active role in the management of your account and investments. Those mutual funds and other investment options your employer provides concerning your 401(k) plan will make you money, yes, but they also come with some fees attached. Look through your plan, alone or with an investment manager or specialist, to find the investment options with the lowest fees and most attractive opportunities for growth based on your own personal and longterm plans and needs. Lowering these fees now will keep more of your money right where it belongs down the road — in your 401(k). 

As far as penalties are concerned, while you can take money out of your 401(k) plan early, you can do so only under very specific circumstances such as via a loan for certain purchases (like buying your first home) or a "hardship withdrawal." You'll still face a possible 10% penalty fee when taking money out of your account and have to pay taxes on the amount you withdraw as well. You'll also obviously have decreased the amount of money you have to retire on and may want to make building it back up a priority as soon as you can.

4. Consider diversifying your savings efforts.

Just because you have a 401(k) plan through your employer doesn't mean you can't start other retirement savings accounts on your own as well. IRAs (Individual Retirement Accounts) and Roth IRAs are both very common additional retirement savings accounts. IRAs allow you to invest in stocks, mutual bonds and other options much like a 401(k), only with more control over the companies and stocks in which you choose to invest (your 401(k) is limited by the options offered by your company). Roth IRAs differ largely in that you pay into them out of your after-tax pay, but then you're never taxed on that money again. There aren't any early withdrawal penalties either. 

Having more than one account, especially ones that offer more flexibility in certain areas, is a good idea. And don't knock the benefits of a good old-fashioned savings account either. Manage your 401(k) plan and all the other ways in which you're socking away money for your golden years carefully. This money is just as important as the nest egg you might be feeding to buy a house or travel the world.

FAQS

What happens if I have a 401(k) plan but then I quit my job?

Part of understanding what a 401(k) plan is and how it works is understanding just what can happen to it. If you quit your job, your now-previous employer is required by law to send you all the options available to you regarding the 401(k) plan you had through them. Be aware that there may be crucial deadlines regarding these decisions, so make sure to understand your options and choose what's best for you before any of these deadlines pass, thus severely limiting your options. Generally, those options are: 

  • Do nothing, in which case your previous employer may decide to just cut you a check for the amount you saved, less the tax fee. You might also get knocked with that early withdrawal fee as well since you'll technically be cashing out the account.
  • Leave your account where it is, but your previous employer may now charge you a fee for continuing to manage the account.
  • Transfer your old 401(k) into a new one with your new employer, which only works if you actually have a new employer within the given time frame you may have to make these decisions.
  • "Roll over" your 401(k) plan — transfer it — into an IRA or another personal retirement account. If your new employer doesn't offer a 401(k) plan, this option may be the best choice.

What are the benefits of a 401(k) plan?

Any kind of savings account is an excellent thing to have. Everyone needs that buffer for unexpected repairs or other expenses, periods in which you're ill or otherwise can't work, big life expenses and, of course, retirement. A 401(k) plan is nice in that it can be a more or less "set it and forget it" situation, unless you take a more active part in managing your investments. Even if you do, you don't have to remember to take out the money from each paycheck to move it over to this account. Your employer will do that for you and potentially match that amount as well, a major plus. And don't forget that this money is invested and grown tax-free.

Where does my 401(k) money go?

You should know just where that money you're investing into the retirement account actually is while you're spending all this time paying into it. Your money is usually allocated to a third party, an administrator who manages your investments in mutual funds, stocks and other options. Neither your employer nor your plan administrator is likely to counsel you on which of the investment options provided are best for you, however, so consulting with your own investment specialist or educating yourself on at least the basics of investing is, again, wise.

Will I lose my 401(k) if I get fired?

You won't lose any of your own personal contributions to your 401(k) plan should you end up getting fired. You may, however, lose any matching contributions your employer made to the account over the years. The company may also require you to move or cash out your account, choosing not to offer you the option of continuing to manage it for you. If you don't already have an IRA or another personal retirement account, setting one up in a hurry can be stressful, especially if you're now also trying to find new work as well. This is still your money though, so while not ideal (since you'll be paying the early withdrawal penalty fee and taxes), cashing out your 401(k) plan means you'll have money to float you until you find a new employer. You'll just be starting over from scratch when you find another employer that offers a 401(k) plan.

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