What is a 401(k) and Why Do You Need One?

Looking forward to spending your years in retirement kicked back, relaxed, and without a financial worry in mind? If so, you’ll want to start saving for retirement now.

One of the best ways to potentially do this is with a retirement account like a 401(k). This specialized account will allow you to save— and grow— your money for the future. Here are the basics you should know about 401k plans, how they work, and why you need one.

Why is it important to save early for retirement?

Retirement savings allow you to live your later years in comfort and financial security even though you’re no longer earning a steady paycheck from a job. Your retirement nest egg will allow you to pay the bills, maintain a standard of living, and perhaps even travel or spend time doing things that you love.

If you’re years— or even decades— away from retiring, saving up for your post-working years may not seem like it should be a priority. However, you’ve probably heard many people say that the best time to start saving for retirement is now, and they’re right.

Why?

It all comes down to compound interest. When you contribute to a retirement account, any interest you make on the investment will go back into the account. As you continue to contribute, the amount within the account also grows, multiplying the effect of the interest per year. The more you put in, the more you’ll earn.

For example, let’s say you have $5,000 in a retirement account and it’s invested in the stock market. Let’s also estimate that the market returns an average of 7% interest. Because of the way a retirement account is set up, every year the interest you earned is reinvested into the account.

There is no guarantee, but this is what your balance might look like after one year:

Year One: $5000 + $350 (7% of your balance) = $5350.

And in year two, instead of potentially earning 7% on just $5000, you’ll be potentially earning 7% on $5350.

Year Two: $5350 + $374.50 (7% of your balance).

You didn’t contribute anything more, but your investment is making more money. In twenty years, that same $5000 will be $19,348.42—without any extra contribution on your part.

How much would you make if you contributed every year? For example, if you started with $5000 and contributed $5000 every year, you would have $238,674.31. You only contributed $100,000 but ended up with more than double. This is the power of compound interest!

This is a very basic example, and the stock market certainly isn’t predictable from year to year. But the basic idea remains the same: if you contribute regularly to a retirement investment account over a long period of time, you might be able to turn a small amount of money into a larger amount.

What is a 401(k) plan and how does it work?

A 401(k) is a private, employer-sponsored retirement account that you can contribute to straight from your paycheck. The 401(k) gets its name from the section of the tax code that authorizes them.

Opting in to a 401(k) or a similar employer-sponsored account is a great way to save for retirement without having to think too much about it, says Garrett Prom, founder of Prominent Financial Planning in Austin, Texas. “It’s very automatic, and people generally don’t miss that money as much as they do if they’re writing a check,” he says.

Note: The 401(k) equivalent for nonprofit employees is a 403(b), and the equivalent for government employees is a 457 plan. They involve different parts of the tax code, but they operate very similarly.

How a 401(k) Works

Your human resources manager or employee handbook will tell you if your company offers the option to contribute to a 401(k). When you sign up, you’ll choose a percentage of your salary to contribute each pay period. These are known as “elective salary deferrals” since you’re essentially choosing to get paid later on, when you retire, instead of right now.

Your contribution will come out of your earnings before federal and state income taxes are taken out. This means that your taxable income will be lower, resulting in lower income taxes when April rolls around.

How Employer Matching Works

Many employers offer a “match,” meaning the company will match your 401(k) contributions with the company’s own funds. It’s free money that will make your account grow faster, and companies offer it to encourage employees to save more.

The best thing you can do for your retirement savings is to contribute at least the maximum percentage of your salary that your employer will match, says Steven Podnos, principal of Wealth Care LLC in Merritt Island, Florida.

“Make sure that you are salary deferring enough to get every dollar and match that you possibly can,” he says. “Because the return is spectacular.”

There is usually a small catch with matching contributions, however. You can’t keep the match until you are fully vested. To become vested, you’ll need to stay with the company for a certain amount of time. While you will always be entitled to your contribution amount, you may have to forfeit all or part of your employer’s match if you leave the company before you are vested. Keep this in mind if you are considering taking a job elsewhere. Be sure to check with your employer’s policies for more information on vesting.

What is a solo 401(k)?

You might be wondering, “Can I get a 401(k) if I’m self-employed?”

The answer is yes, through something called a solo 401(k).

Single-participant 401(k) plans are designed to cover freelancers, self-employed individuals, and business owners that have no employees. These plans function similarly to an employer-sponsored plan and are bound to the same rules and requirements.

Once you’ve determined that you’re eligible for a solo 401(k), opening one is not difficult. First, you’ll need to find a broker or investment firm that offers the product. From there, the process is pretty straightforward— you’ll provide your EIN, a plan adoption agreement, and an application. After you’re approved, you can set up your contribution plan!

And, if you ever hire employees or go to work elsewhere, you can always convert your account or roll your money over into a new plan.

401(k) FAQ

Here are some answers to some of the most common questions we get pertaining to 401(k)s.

What is the difference between an IRA and a 401k?

An IRA and a 401(k) are not the same thing, even though they both share the goal of helping you save for retirement. Like a 401(k), both the traditional IRA and Roth IRA are tax-advantaged. However, an IRA typically offers a wider range of investment options and is not tied to an employer. Opening and contributing to an IRA is done on an individual basis through a broker or bank—for example, you can sign up for an IRA with Amplify Wealth Management through CUSO Financial Services, L.P. (CFS*).

Where does my 401(k) money go?

Your 401(k) isn’t a static bundle that grows at the same interest rate each year like a savings account. It gets invested, and, in most cases, you can choose how your money is allocated: in stocks or bonds, for instance, or in a mutual fund that changes the type of investments you make based on when you plan to retire, called a target-date fund. Where your money goes — and how risky that investment is — dictates how high your rate of return will be, or how much your money will grow over time.

How do I choose where to put the money in my 401(k)?

The investment choices in your 401(k) can be overwhelming, especially if you’re new to the process. Your best bet is to read carefully through all the options you have, research on your own online, and consult with a financial advisor to determine the best plan of action for your financial situation.

You may also decide to opt into something called a managed 401(k). With a managed 401(k), a professional portfolio manager will handle your investment account and decide the best course of action for your account based on factors like current age, planned retirement age, and more. This is a great option if you don’t have the time or desire to manage your assets on your own.

When can I start using my 401(k) money?

You can withdraw money from your 401(k) without penalty when you’re 59 ½. If you dip into it before then, you’ll pay a 10% penalty. In either case, you’ll pay income tax on your contributions and interest earned based on the tax bracket you’re in when you withdraw. Since most retirees make less income after retirement and are in a lower tax bracket, waiting to withdraw is a good idea.

Start Saving Now

The key to financial security in retirement is starting your savings early. A 401(k) is a great benefit offered by many employers that allow you to save and grow your money for when you need it down the road. To learn more about 401(k)s and whether they are right for you, consult with a CFS* financial advisor to help you make the best decision for your future.