How Do 401k Plans Work?

People often talk about 401k plans associated with benefits, such as free money from employers, lower taxable incomes, and savings for retirement without deposits. Overhearing these tidbits of information may make you wonder what is a 401k plan? Well, it is a type of retirement plan that is offered to individuals through their employers. It is the most common kind of retirement savings plan with defined contribution.

How It Works

With this retirement plan, you decide how much or how little you want to contribute from your paycheck. Then, the employer places the money into the account for you. This payroll deduction allows a percentage of your salary to go right into the account without having to lift a finger. Although your paycheck will be smaller, the money will be held safe for later on in your life when you no longer work.

Your employer will send the 401k contribution from each check to the company that manages your plan. Typically, these are mutual funds companies, brokerage firms, or insurance companies.


How Much to Contribute

Because of the plan’s tax breaks, it is wise to invest as much as you comfortably can each year. However, there are annual limits placed on these plans. These contribution limits change often due to inflation. Be aware of these limits and try to contribute the maximum allowed.

For help determining how much you want to contribute each year, use a 401k calculator to calculate how much income you can expect during retirement at the current contribution rate. Then, you can make any necessary changes depending on the results measured. The Human Resources Department for your company can also help with telling you how much to contribute for the greatest match.

How to Get the Money

Some hardship situations that life throws at you might make withdrawing from your 401k plan a necessity. If you are younger than 59 years old and are still working for the employer, the IRS will only allow withdrawal from a 401k if it is a heavy financial necessity. These cases include paying medical bills, college tuition, the purchase of a new home, or funeral costs. Just with any other type of loan, the amount that you take out will be owed back to the 401k company, along with interest. There may also be fees added as a penalty to withdrawal.

After this inside look at how the plan works, you should decide whether it is a good option for you. Talk to your employer about what they currently offer for more information.