What is a 401K and how does it work?

What is a 401K?

In short, a 401K is a retirement/investment account offered by employers. Since it’s an employer offered plan, it’s not available to those who are self-employed (if self-employed, consider a Roth IRA account instead).

If your company offers a 401K plan, sign up as soon as possible! Otherwise you’re losing out on free money. Yes, free money! Do you want free money? Of course, so please take advantage. Okay, let’s see how it works.

How does a 401K work?

At a high level, both you AND your employer contribute money into the 401K account from each paycheck you earn.

You’ll be able to contribute as much as you like to your plan. However, your employer’s contribution will vary based on your company’s policy.  You see not every 401K plan is the same so you should familiarize yourself with your employer’s plan to understand the specifics.

The most important piece is the matching rate. Some companies might match your contribution 100% up to a certain percentage. Other plans might only match 50% of your contribution. Let’s look at some specific examples to see how this works.

Example 1 – 100% contribution policy

Let’s say your employer offers a 100% match up to 4% of your contribution. If you choose to contribute 2% of your paycheck to your 401K, your company will also contribute 2%. So, a combined 4% will go into the 401K account. If you choose to contribute 4% of your paycheck, the company will also match the 4% for a total of 8%. Now, what if you want to contribute 10%? You can do this of course, but your company will still contribute the maximum 4% so a total of 14% will go into your 401K account.

Just to make it crystal clear, let’s look at the actual math. Let’s say you’re paid weekly. You work 40 hours at a rate of $25/hour. Thus, your gross pay for the week is $1,000. Let’s say you want to get the maximum contribution from your employer, so you elect to contribute 4% of your gross pay to your 401K. If you do the math, that means you’re putting in $40 and your employer is putting in $40. So, a total of $80 is going into your 401K account. You see, free money!

Example 2 – 50% contribution policy

Let’s say your employer offers a 50% match up to 6% of your contribution. You’re smart (very smart), so you decide to maximize your employer’s contribution. You elect to contribute 6% of your paycheck. Your employer will match this 50%, so they will contribute 3% (50% of your 6% contribution). So the total contribution is 9%.

Let’s review the actual math once again. Your weekly pay is $1,000 (like previous example). You elect to contribute 6% of your pay to the 401K account. Your contribution will be $60, and your employer’s contribution will be $30. A total of $90 will go into your 401K account.

As you can see, the math is straightforward. You just need to understand your company’s policy to make sure you’re taking full advantage. If your company is offering a match up to say 10%, you want to make sure your contributing 10%. Not 5%, not 7%, not 9%. Elect the full 10%. Maximize your company’s contribution.

Wrap Up

The key takeaway is to make sure you’re taking full advantage of your employer’s 401K plan if it’s something that’s available to you. It’s basically free money for your retirement. Invest the time (shouldn’t take more than 15 minutes) to familiarize yourself with your company’s plan since it may not work exactly as described above. For employees, the 401K account is THE key tool for retirement. Start contributing as early as possible and contribute as much as possible.

One very important point not discussed above. Don’t let your company’s maximum match policy dictate how much you contribute to the 401K. Say your company only matches up to the first 3%, you shouldn’t elect to only contribute just 3%. This is just the MINIMUM to take full advantage of the company match. Instead, you should strive to contribute at least 10% to make sure you’re adequately funding your retirement.

Other helpful 401K blog posts on SmartMoneyBlogger

What is the max 401K contribution for 2019?

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