How Does a 401 (k) Plan Work?

How Does a 401 (k) Plan Work, July 2021

Say you’ve been working a 9 to 5 job and wanted to save something up for retirement. Unfortunately, you can’t seem to keep hold of your money, and you end up spending most of it anyway, whether on bills or other necessities.

Luckily though, there’s something called the 401k plan that can help you out. But what is a 401k plan? How does 401k work?

In its most basic terms, the 401k plan is a way for you to save up for retirement. You contribute a certain amount from your monthly salary, which is then invested somewhere, and whatever profits produced are placed into an account.

You can withdraw the contents of this account without penalty once you reach 59 and a half years old.

Getting Started

Once you get into a new job, usually in the first few days, you’ll be presented options on how you’ll want to work on your 401k plan.

You can choose where you want to invest your money and the amount you want to contribute every year.

Now, most of the time, the decision-making stops there for you, and you wouldn’t have to worry about it until you retire one day, or if you need to withdraw the profits.

401k plans are managed by your employer, who is considered to be the plan sponsor. They’re the ones who handle the investment side of things. Employers would sometimes also help add to your contributions every year.

This is known as an employer match, where they may contribute 50 cents or $1 for every $1 you contribute. This is a common practice, but it’s not a general rule.

If you’re self-employed, you can set up your own 401k, with the same benefits and limitations as the ones you’d get from a normal job.

How Much Can You Contribute?

Now before you decide to contribute a huge chunk of your salary, there is a limit to how much you can contribute to your 401k plan every year.

The limit itself changes every year, but as of writing, it’s about $19,500 per year for anyone under 50 and $26,000 for everyone older.

If your employer decides to match your contributions, there’s also a limit to consider.

You and your employer can only contribute a maximum of $57,000 a year, and $63,500 if you’re older than 50.(1)

What Can You Invest On?

Graphic art of a hand dropping coins on an opened laptop

You usually get a wide range of options on where you can invest your money.

Your employer might present you with a selection of stock and bond choices, guaranteed investment contracts, money market funds, and more.

On average, you can get as many as 25 investment options at any given time, so there’s plenty to choose from.

Your employers might also give you an option to use your contributions to buy shares of stock in your company at a discounted price. 

This can be a bit risky if your company suddenly goes downhill before you can withdraw the money, but it’s still an option.

The Tax Benefits

One of the biggest benefits of investing in your 401k plan is that whatever money you put into it isn’t being taxed.

You’ll only be taxed once you decide to withdraw the money, but once you reach a certain age, or if you meet certain requirements, you can withdraw the money tax-free.

This mechanic is in place so it’ll encourage people to invest in their retirement.

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