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What is a 401(k)?

Over the last week, I’ve discussed a few different ways you can save and grow your money for retirement, all while maximizing your growth and receiving special tax benefits. Both the Roth and Traditional IRA are individual accounts, meaning anyone earning taxable income can open them. Today, I’ll be talking about the 401(k), a tax-advantaged account that companies offer to their employees.

The biggest difference between a 401(k) and an IRA is the fact that an individual cannot open a 401(k) for themself unless they are self-employed. A 401(k) plan is offered by employers to their workers, and much like the IRA, there are two kinds of 401(k)’s, the Traditional 401(k) and the Roth 401(k).

If you work for a major company like McDonald's, Starbucks, or another similar corporation, you'll almost certainly have a 401(k) plan available to you. Ask your manager about your options.

Like with a Roth IRA, a Roth 401(k) is funded by post-tax money, meaning you’ve already paid income tax on the money you contribute to the account. I’ll discuss this kind of 401(k) in Saturday’s article.

A traditional 401(k), like a traditional IRA, is funded by pre-tax money, meaning you haven't paid taxes on the money you contribute to the account. You can also deduct the amount you deposited on your tax bill, reducing your overall tax payment. However, once you decide to withdraw money from the 401(k), you will have to pay taxes.

The biggest difference between a 401(k) plan and an IRA is the available investments. Because your employer/company offers the 401(k), the investment choices are slimmer. In an IRA, you can invest in nearly every available asset, including stocks, bonds, futures, ETFs, and index funds. In a 401(k), you are limited to only what your employer offers. This does not mean the investments are bad, it simply means that there are fewer choices.

Most employers opt for low-risk investments in the form of professionally managed funds. This means you can invest in, say, a mutual fund (a pool of money managed by professionals) or a target-date retirement fund, to name a few choices. A target-date retirement fund is a fund in which you select an estimated retirement year, say 2060, and the fund makes investments based on how close you are to retirement. The closer you are to retirement, the lower the risk level of the investments.

However, this limitation comes with a couple major benefits. The first is the fact that many employers will offer to give you money for retirement in the form of a 401(k) employer match. This means that your company will add money to your 401(k) as long as you add money yourself. Oftentimes, it is in the form of a percentage of your salary/pay, up to a certain amount.

For example, your employer will add $1 for every $1 you add to your 401(k) up to 10% of your salary. So, if you make $20,000 and you choose to contribute $2,000, your employer will match that $2,000 so you have a total of $4,000 to add to your 401(k). However, if you go any higher than $2,000, your employer will no longer match, as $2,000 is 10% of your salary, the maximum amount they're willing to match. So, even if you add $5,000 to your 401(k), you’ll still get only $2,000 from your company. It's always good to take advantage of a match program because it's as close as it gets to “free money”.

Additionally, the limit for a 401(k) plan is much higher, while an IRA maxes out at $6,000, the 401(k) maxes out at $19,500.

While a traditional IRA and a traditional 401(k) may differ in the amount you can contribute, the penalties for early withdrawal and the minimum distribution restriction remain the same.

If you withdraw money from a 401(k) before the age of 59 ½, you will have to pay a penalty and pay any taxes owed. Additionally, once you reach the age of 70 ½, you have to start withdrawing from your 401(k), you can't just let it sit. The IRS sets the minimum amount you must withdraw.

All in all, a traditional 401(k) is a great way to save for retirement while also receiving extra money from your employer and saving on taxes.

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