What is a 401K plan?

Question

I understand that it is a method to save money and put it away for after your retirement, but I actually have no idea what it involves and how it is done and what exactly it is. I don't need to know for any particular reason because I'm still a student but I was just wondering.

Answer 1

The name 401(K) comes from the actual number of the section of the law in the tax code.  Tax code 401(K) says that, through a program with your employer, you can have a percentage of your paycheck withheld, before taxes are even withheld, and that money becomes your contribution to a "deferred retirement plan".  Employers administer the program as a benefit for their employees, mostly so that they don't have to offer a pension anymore.  A 401(K) plan is a retirement plan run by a "for profit" company.  A non profit like a hospital or a fire department  has the same type of program but it is called a 403(B), also named for the tax code section that describes it.

   Each employer can decide what kinds and types of investments that are offered by the Plan.  The choices can be mutual funds, company stock, bonds, or whatever they choose from the investments that are on the list of "approved" investments under Federal Law.  An "unapproved" investment would be something speculative like drilling for natural gas on the moon or looking for uranium or gold under Manhattan.  401(K), 403(B), and IRA plans are prohibited from offering "unapproved" investments.

  Anyway, the money is withdrawn right off the top of your income before taxes, so it makes your taxable income less each year that you contribute to the 401(K).  That money, and any money that your employer "matches"[ puts into your account, employers usually match your contribution up to 3%-6% of your salary that you contribute to the Plan] is invested in any way that you choose within the Plan offerings and all of that money grows tax "deferred" until you withdraw money from the Plan.  Then the money that you withdraw is taxed at whatever your income tax rate is when you withdraw it.  However, if you leave your employer or retire, you can "roll over" your 401(K) money into a self directed traditional IRA.  Then your IRA grows [we hope] and you can start to withdraw money at age 59 1/2 without penalty or you can leave it until you are age 70.  At age 70 you are required to start taking "minimum distributions", which is a percentage of the money that must be withdrawn according to your age. And hopefully by that time, if you have made your maximum contributions each year, you are a millionaire.

Answer 2

It is a benefit provided by the company you work for.  You already defined what it is.  Some employers match dollar for dollar of what you put in up to 6% of your salary.  Some companies allow you to choose what investment vehicles you want and others just allow investments in the company's stock.  The money is not taxable until you start to withdraw it.

j

Answer 3

It is a retirement account.  Typically it is set up by your employer.  The employee puts a certain amount of salary into the account and the employer matches a certain amount of that amount...normally 6%.  The contributions are divided up between stocks and other funds.  You can lose money, you can make money...depends on how aggressive you go with your portfolio and how well it does.