What Is a 401(k) Plan and How Does It Work?

What Is a 401(k) Plan and How Does It Work?

•  3 minute read

If you have the opportunity to open an employer-sponsored 401(k) plan, seize it. Here's why these retirement savings accounts are too good to pass up.

Until I started working full-time and receiving benefits, I had no idea what a 401(k) retirement plan was. Then I found out and laughed. You’re telling me you’re going to deduct even more money from my paycheck on top of all these federal and state income taxes? Ha — fools!

Well, it turns out that I was the only fool in this situation. I was leaving free money on the table. Let me explain.

 

Getting Free Money to Invest

Investing is synonymous with risk. In a sense, it’s a less reckless form of gambling. Any time you choose to invest in a stock or a company, you risk losing your money. Just ask all those millennials who threw their money at Snapchat. That said, why wouldn’t you take free money to invest?

 

What Is a 401(k) Plan and How Does It Work?

Many employers offer 401(k) retirement plans as part of their benefits packages in addition to health benefits like dental and vision care.

This is meant to encourage employees to put money away for their future before they’ve ever seen that money. For all the irresponsible individuals who don’t invest on their own, employers make it easier by taking the money off the top before you ever see it.

For example, let’s say that you make a base salary of $50,000 per year and your employer offers you a five-percent match when you invest five percent of your own money. With that match, you’re getting free money! If someone told you you’ll get to invest double your money by putting up just half of it, why wouldn’t you?

$50,000 x 0.05 = $2,500 + free $2,500 = $5,000

If you invested five percent the first year and received five percent from your employer, you’d get to invest 10 percent of that money, totaling $5,000. With compound interest, that money will only grow over time.

 

The Power of Compound Interest

Growing up, I never cared much for math. But when the teacher started talking about increasing my money, I paid attention. The equations were still too complicated for me to comprehend, but I did understand that if you put money in the bank and it gains interest every year, then it grows exponentially over time.

If we take our $5,000, continually reinvest that same amount of money over 10 years, and get a modest stock market return of eight percent annually, we end up with $89,000 over that span of time. Considering that we invested $50,000, we nearly double our money simply by saving for retirement and letting it sit in an investment account.

I won’t bore you with the equation. A compound interest calculator will show you these returns. These returns are also very conservative. An eight percent return is a bad year. Still, that’s better than the return you’ll get by parking your money in the bank.

Over the course of 10 years, your income will probably double or even triple. This means that the low $5,000 contribution will turn into $10,000 — or maybe even $15,000 — as you have more money to stow away. We know that the more money we put away now, the more it will have ballooned by the time we retire.

Key Takeaways
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    If you don’t contribute to your 401(k) with the employee match, you’re throwing free money away.
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    Contribute at least the amount that will get you a full employee match.
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    Compound interest means that if you start investing young, your money will grow exponentially.
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    Consider investing in a Roth IRA instead of a 401(k) if an employee match is not available.

When Not to Contribute to a 401(k) Plan

A 401(k) retirement plan is great because all your contributions are pre-tax income. However, you’ll eventually have to pay taxes on the earnings from the money you contributed.

That time will come when you’re gearing up for retirement. By then, your income will most likely be substantially more than it is now.

You might want to regularly check in on your 401(k) using tools like Blooom in order to make sure that you’re still making the most bang for your buck.

Unfortunately, some companies — small start-ups, for instance — might not be able to afford to provide an employer-sponsored retirement plan. If this is the case at your company, you may want to consider other options for your retirement account.

For example, investing in a Roth IRA will mean that you’ll get taxed on your contributions right away. Though taxes always hurt, your money will grow tax-free. When you retire and withdraw this money, it’s all yours.