What is a 401(k) and How Does it Work: A Complete Guide

The main difference between a Roth and a Traditional 401(k) comes down to taxes and when you pay them. With a traditional 401(k) the money is pre-taxed. So, your contributions are taken out of your check before taxes are deducted. This lowers your taxable income right away. But there’s a catch, when you withdraw that money in retirement, you’ll have to pay taxes on whatever you take out.

On the flip side, with a Roth 401(k) the money you contribute is with after-tax dollars. Meaning that your income is taxed up front, before going into the account, so no upfront tax break. But here’s the best part: when you’re ready to start pulling money out in retirement, you won’t pay any taxes on it. So, either way, you have to pay Uncle Sam, it just depends on when.

One of the best features of these accounts is that your employer often contributes too. This is called “employer match, ” and basically it’s free money. Your company will match what you contribute to your retirement account, but only up to a certain percentage of your income.

For example, if they offer a 5% match, that means for every dollar you put in, they’ll throw in a dollar too—up to 5% of what you make.

Make sure you’re contributing at least enough to get the full match, or else you’re leaving money on the table.

Let’s chat about vesting—it’s a super important concept when it comes to your 401(k). So, what does it mean to be “vested”? Essentially, vesting is all about when you actually own the money that your employer contributes to your 401(k). When you start a new job and your employer offers a matching contribution, you might not get to keep that extra cash right away.

Vesting schedules set a timeline for how long you need to stay with the company before those employer contributions are fully yours. Similar to a kind of bonus for sticking around: if you’re fully vested, it means you own 100% of the employer’s contributions, while being “partially vested” means you own a portion based on how long you’ve been at the company.

If you leave your job before reaching full vesting, you could lose some of that employer match. So, it’ pays to ‘s a good idea to check out your company’s vesting schedule so you know what you can count on.

Unfortunately, there’s a 401(k) max limit on how much you can put into your account each year. For 2024, that limit is set at $23,000. But here’s the thing: the money you put in doesn’t just sit there doing nothing. Thanks to compound interest, your investments have the potential to grow over time.

Now, because these accounts are designed to provide for you during retirement, the IRS doesn’t want you dipping into the funds too early. If you try to take out money before you turn 59 1/2, you’ll get hit with a 10% withdrawal penalty, plus you’ll have to pay regular income tax on whatever you withdraw. However, there are some exceptions to this rule. For example, you can make early withdrawals for things like buying your first home, covering certain medical expenses, or adopting a child without facing that extra penalty.

And speaking of rules, there’s something called Required Minimum Distributions (RMDs). This is when the IRS requires you to start withdrawing a minimum amount from your retirement accounts once you reach a certain age, making sure you’re using the money rather than just letting it sit forever.

If you’re approaching retirement age and feel like you haven’t saved enough, don’t panic! The IRS allows people aged 50 and over to make catch-up contributions to their 401(k)s. For 2024, this means you can contribute an additional $7,500 on top of the regular limit, giving you a chance to up your savings in those final working years. It’s a good way to play catch-up if you feel behind in your retirement savings.

Here’s a little secret that can make a big difference: keep an eye on the fees associated with your 401(k). While investing is key to growing your retirement savings, those fees can chip away at your returns over time, without you even noticing. Understanding the different types of fees involved like expense ratios and administrative fees will help you make smarter choices about where to invest your money.

To stay informed, request a fee disclosure statement from your employer’s plan provider, which outlines all the fees associated with your 401(k). By being proactive about understanding and comparing fees, you can significantly affect how much you have saved when it’s time to retire.

One of the biggest misconceptions is that you have to be wealthy to start contributing to a 401(k). In reality, even if you’re just starting your career or working with a modest paycheck, you can contribute a small percentage of your income. The important part is to start saving early; even small amounts can add up over the years thanks to compound interest.

Another common myth is that if you leave your job, you’ll lose all the money in your 401(k). Not true! When you change jobs, you typically have several options, including leaving your funds in your old employer’s plan, rolling them over into your new employer’s 401(k), or transferring them to an IRA. Each choice has its pros and cons, so it’s worth considering your situation before making a move.

Some folks also believe that 401(k)s are only for retirement and can’t be used in emergencies. While it’s best to avoid pulling from your 401(k) early, there are some exceptions that allow for hardship withdrawals—like for medical expenses or buying your first home—though penalties might apply.

Another myth people often believe is that you can’t change your investments once you’ve set them up. In fact, you can adjust your investments as your financial goals change or as new options become available, so don’t feel stuck with your first choices!

Lastly, many people think they can just rely on Social Security when they retire and don’t need to worry about their 401(k). Unfortunately, relying solely on Social Security for retirement income might not be enough to maintain your future lifestyle. Social Security was designed to supplement your retirement savings, not replace them. Having a beefy 401(k) gives you an income source that can help you enjoy your retirement without financial stress.

The good news is that you have several options when it’s time to changing jobs, and understanding these choices can help you make the best decision for your future. First, you might choose to leave your 401(k) with your former employer. Many plans allow you to keep your money there, which can be a convenient if you’re happy with that plan. Just keep in mind that you won’t be able to contribute to it anymore, and you’ll need to stay informed about the plan rules.

Another popular choice is to roll over your 401(k) into your new employer’s 401(k) plan, assuming they accept rollovers. This keeps your retirement savings together, making it easier to manage. If you do this, make sure to check the new plan’s investment options, fees, and any potential restrictions.

If the new plan doesn’t offer what you’re looking for, you can also roll your 401(k) into an Individual Retirement Account (IRA). This can offer more flexibility and a larger range of investment options. Just be sure to follow the rollover rules to avoid any taxes or penalties.

Inflation can take away from your purchasing power over time, so it’s important to to understand how it affects your retirement plans at the most basic level.

Simply put, inflation is the rate at which the general price level of goods and services rises, meaning you’ll need more money in the future to maintain your current lifestyle. This is important when saving for retirement since you want your savings to keep up with inflation, so you can afford the same lifestyle in the future.

One common rule is to plan for a steady inflation rate of around 3% per year, although it can fluctuate. When budgeting for your retirement, think about how inflation will affect your future expenses—like housing, healthcare, and everyday costs. For instance, if you estimate that you’ll need $50,000 a year to live comfortably when you retire, you may need significantly more over the course of 20 or 30 years to match the increasing costs.

As life happens, your priorities and circumstances can change—which is why you should periodically reassess your retirement goals. What you wanted five or ten years ago might not be what you want now or in the future. Changes in your career, family situation, or even your health, reflect on what you want out of retirement to make sure you stay on track with your retirement.

Set aside some time each year to evaluate where you stand with your savings, expenses, and investment choices. Ask yourself questions like: Am I saving enough to meet the retirement lifestyle I want? Are my investment strategies still in line with my risk tolerance?