What is a 401k?

Retirement & Investing
on June 9, 2012

When it comes to handling finances, it seems like there is always something better to spend your money on than saving it for retirement. If you hope to enjoy a comfortable retirement, you have to get serious about it now. Part of planning for your retirement is choosing the right investment vehicle to put your money into. One of the best options that you have is the 401k. What exactly does the 401k bring to the table that would make you want to choose it for your retirement plan?

How the 401k Works

Most 401ks are offered through an employer, although some self-employed individuals also have them. With a 401k, you contribute money to your account on a regular basis by taking part of your paycheck out on a pre-tax basis. Since you are contributing on a pre-tax basis, it means that you won’t notice as much money coming out of your paycheck. The money goes into your investment account, and you can then put that money into security like stocks and bonds. As the investments earn a return, that money is added to the account on a tax-deferred basis. After you hit retirement, you can start taking the money out. You will then pay taxes on that money at your appropriate tax rate at the time.

Employer Match

One of the most attractive features of the 401k is the employer match. Many employers offer this as an incentive for employees to save for retirement. When you put money into your account, your employer has the chance to match your contribution up to a certain percentage. For instance, if you put four percent of your paycheck into the account, your employer might put two percent in. This is basically free money that you can use to invest with. The employer has an incentive to do this, because he gets to use this as a tax deduction for the business.

Contribution Limits

Another advantage of the 401k is that it has very large contribution limits. With an IRA, you can only put up to $5,000 into the account annually or $6,000 if you are over 50. With a 401k, you can put in up to $17,000 per year or $22,500 annually. This allows you to set aside a lot more toward your retirement comparatively.


If you are looking at different retirement account options, the 401k is one that you need to consider. If you don’t work for an employer that offers one, then you probably won’t be able to invest in one. In this situation, your only option is to start a solo 401k, if you are self-employed.

One of the drawbacks of the 401k is that it may not have very many investment options. You can typically invest in a few different funds, stocks, bonds, and possibly annuities. If you want investment flexibility, an IRA may be an option to consider.

If your employer does offer a 401k, it’s obvious that you should be contributing the maximum amount that you can. This way, you’re not leaving money on the table for your retirement.

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