According to the 2019 National Study of Millionaires by Ramsey Solutions 8 out of 10 millionaires used company 401(k) plans to build their wealth. Many Americans already have access to a 401(k) through their employer which can make it a great option for getting started with investing. So, what is a 401(k)?
A 401k is a tax advantaged, employer sponsored, defined contribution, retirement account.1 Now what does all that mean?
Tax Advantaged
Tax advantaged is exactly what it sounds like. There are certain tax benefits to investing in a 401(k) that you won’t receive from non-retirement investment accounts. These benefits could add up. With the pre-tax (traditional) option you get a tax deduction for the amount you save each year and taxes on the growth and income are deferred until you take money out in retirement. With the Roth option you don’t get a tax deduction for the amount you save, but the growth and income of the investments are tax free when you take the money out during retirement.2
Employer Sponsored
This means that the company you work for is setting up and maintaining the plan as opposed to you going to a brokerage firm or financial advisor and opening an account on your own. The contributions you decide to make are taken out of your paycheck which makes saving money simpler and removes the temptation to spend the money instead of investing it since you don’t ever see that money. Some employers cover the administrative costs and large plans may have access to lower cost mutual funds than you could access on your own. For these reasons, your 401(k) has the potential to be a low-cost option with less administrative burden on you as the investor. If your employer makes matching or profit-sharing contributions for you, that is a huge bonus.
Defined Contribution
There are two general categories for retirement plans, defined benefit and defined contribution. A defined benefit plan is one that guarantees your monthly benefit in retirement. This would include traditional pension plans that give you income in retirement based on a certain formula. A defined contribution plan specifies how much goes into the plan but does not guarantee how much will be there at retirement. This is where the 401(k) falls. Your company agrees to contribute, match, or allow you to put in a certain dollar amount, but there is no guarantee about what the balance will be when you retire. The value at retirement is dependent on how much you save, how it is invested, and how much the cost is.
Retirement
These types of accounts are designed for retirement use. Once money goes in, it is not easy to take it out until you reach 59 1/2. If you can take it out before 59 1/2 whether through a loan, hardship, or otherwise, there are usually tax consequences for doing so. So, while these accounts have great tax benefits, they are less flexible when it comes to uses unless you are over 59.5. So only put money into your 401(k) that you plan to use for retirement.
Account
A 401(k) is not an investment. It is an account that you can hold investments in. Most plans allow you to choose how you want to invest the money in your account, but some are managed for you. You can invest in relatively safe investments like money market funds and stable value funds that have low expected return, you can invest in more risky investments like emerging markets stocks that have higher expected returns, or you can invest in a variety of places in between. The return you can expect in your 401(k) depends on the investments inside.
All these features and more set apart 401(K)s as very useful retirement saving tools.
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- 26 U.S. Code § 401(a) and 26 U.S. Code § 501(a), 26 U.S. Code § 401(a), 26 U.S. Code § 401(k)(2)(a), 26 U.S. Code § 414(i),
- 26 U.S. Code § 401(a), 26 U.S. Code § 501(a), 26 U.S. Code § 408A(d)(1))
