How Does a 401k Work?
A 401k is an investment account. Workers contribute money to the account, and it is invested. In many cases, the contributions are made automatically, taken out of your paycheck by your employer and placed in the retirement account. Over time, the account grows as more contributions are made and as the investments hopefully offer returns. There are two main types of 401k:
1. Traditional: When you contribute to this type of 401k, your money is taken out of your paycheck before anything else, including taxes. These contributions are tax deductible, lowering your income and your tax liability right now. If you contribute money beyond having it taken from your paycheck, you can deduct it from your income when you figure out your taxes. Later, when you withdraw money from your account during retirement, you have to pay taxes on the amount you withdraw.
2. Roth: With a Roth 401k, your contribution comes out after you pay taxes, so it won’t reduce your income right now. However, later on, you don’t have to pay taxes on your withdrawals. A Roth is ideal for those who think taxes will rise before they retire, or who think that they will be in a higher tax bracket during retirement. They pay taxes now, at a lower rate, and avoid the higher taxes later.
There is also the option of opening a solo 401k, or a solo Roth 401k, if you are self-employed.
It’s important to note that you can’t withdraw money from your 401k whenever you want. You have to wait until you are at least 59, or face a 10% penalty from the IRS for early withdrawal. Additionally, you have to pay income taxes if you withdraw the money early from a traditional 401k.
You can borrow from your 401k, but if you don’t repay the loan within a certain period of time, it is viewed as an early withdrawal, and you will have to pay the penalties. If you want more information on the tax implications of the 401k, the IRS offers a number of helpful resources.
What Investments Can Be Held in a 401k?
In many cases, your employer decides what investments you can choose from for your 401k. Usually, you can choose from individual stocks and bonds, or from various mutual funds (including index funds) and ETFs. If your employer doesn’t offer an investment that you want, you can contact the human resources department to ask that it be added.
Many employers also offer what is called a matching contribution, or “match.” Your employer will match your 401k contributions, up to a certain amount. This means that the employer provides you with money for your 401k. This is free money that goes toward your retirement. It is in your best interest, usually, to contribute the maximum so that you may receive the maximum “match.”
Remember, though, that your 401k represents an investment account, so there is a risk of loss. However, over time, long-term investing has been one of the best ways to build wealth, and the length of time you hold a 401k account may reduce some of the risk that is due to volatility.
Disclosure: We are not tax advisors. This article is not tax advice.