What is a 401(k)? And why do you need one?

March 24, 2020, 8:00 AM UTC

Not that you need more things to be stressed about right now, but does hearing the term “401(k)” leave you sweating? It can seem daunting, but a 401(k) is just an account designed to help you save money for retirement. Yes, it’s truly as simple as that. 

Employees across generations need to be thinking about retirement funds more carefully—especially now that the economy is set to be radically transformed through the coronavirus pandemic. A 2018 survey by Personal Capital of over 2,000 Americans, 1,630 of which were pre-retirees, found that an average of 37% had no money saved for retirement. This included 32% of baby boomers, 34% of Gen Xers, and 39% of millennials, showing a minimal change as people moved closer to retirement. 

While money constraints limit the amount and ability for some people to invest in their 401(k), a refresher on the importance of 401(k) plans is always handy to start planning for retirement—whether you’re just starting out in your career or are already decades in.

How does a 401(k) work? 

Instead of having to remember to file random amounts of money away every now and then, you can choose how much to save and how often—and you don’t have to pay taxes on it. Sounds pretty good, right? Seems like you’re going to like 401(k)s after all. 

“A 401(k) is an IRS-approved retirement savings account offered by employers to their employees,” says Taylor Jessee, director of financial planning at investment management firm Taylor Hoffman. Employees can deposit a portion of their paychecks into the 401(k), up to a total of $19,500 a year—although this limit goes up a little each year. Most often your employer will actually match your contribution. “It’s an incentive for employees to save, and to attract and retain talented workers,” says Jessee. 

If, for example, an employer offers to match 3% of what you’re putting into your 401(k) and you contribute the same amount, you are really saving 6% of what you’re being paid. Often employers will match however much you put in, up to a certain amount. 

As for taxes, 401(k) deposits are taken out before your income is taxed. Say you choose to put in $1,000 and your income is $50,000. Only $49,000 would be subject to tax. It’s important to note that any employer contributions cannot be used to reduce your taxable income; it’s only what you personally put in. 

Your money will not be taxed as long as your money is inside the 401(k).

“Money inside the 401(k) can be invested in products such as mutual funds and ETFs, and any interest, dividends, or growth in the portfolio is not taxed,” says Jessee. “You only pay tax once you take withdrawals from the 401(k), which ideally is not for decades, when you eventually retire.”

You won’t get away with avoiding taxes on that money forever, but the reduction now, plus increased savings, is a win-win. 

Why does a 401(k) matter?

While this all sounds well and good, you may be thinking of skipping the whole process since you could still save on your own. Why bother?

For starters, not having to remember to save can make a world of difference. “For most people, it is an easy way to save automatically for retirement, since savings come straight from your paycheck,” says Brianne Soscia, a certified financial planner with the Wealth Consulting Group. 

A 401(k) also helps ensure you aren’t just relying on Social Security in retirement.

“These 401(k) plans serve a dual purpose: reduce your taxable income, and set you up for income in retirement,” says Katharine Earhart, a partner at Fairlight, an investment management and workforce retirement company.

This is especially important for the 19% of millennials and 29% of Gen X participants in Personal Capital’s survey who reported plans to live off Social Security alone in retirement.

According to Earhart, “Social Security is only meant to be a stopgap measure for most people should a crisis hit in retirement or should they be forced to take early retirement.” Soscia agrees: “The average Social Security payment will not be sufficient to cover many people’s expenses in retirement, so saving for yourself is crucial.”

While the 39% of millennials without retirement savings may not be able to forgo any money at the moment to save, a 401(k) provides employees with the ability to save, no matter how much they can afford.

“If you start saving early, your investment savings will compound over the course of your entire working career,” says Earhart.

If you’re at a later stage in your career and were previously unable to save as much as you would have liked for retirement, there’s good news. Earhart explains, “For people over 50, you can save an additional $6,500 in 2020, which is referred to as a catch-up contribution.”

This increase in funds can help tremendously in securing your finances for retirement, regardless of when you start worrying for it—but the sooner you do, the better.

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