How does a 401k Work?

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December 15, 2020

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Out of the question. Not even remotely doable. Who has money for that? If those are the things you think when someone mentions “saving for retirement,” you’re not alone. Most people don’t feel “on track” when it comes to saving for retirement, and we get it. When you’re working your hardest to pay today’s bills, it can seem impossible to even think about saving for tomorrow.

But the truth is, saving for retirement isn’t just something “rich” people do. It’s something anyone can do. We promise it’s painless and easy with a 401K savings plan. And, like most things in life, the earlier you start, the better off you’ll be.

What is a 401K?

A 401K is a savings plan that lets you contribute money into a retirement account without paying taxes on it. The government actually encourages retirement savings, allowing people to put away up to $19,500 per year without paying taxes until the money is withdrawn at age 59½. For most people, a 401K account is set up through their employer. A set amount or percentage is taken out of each paycheck, so you don’t have to think about it. The money in the account gets invested in hopes that over years and years it will earn even more than you’ve contributed.

The thing that sets the 401K plan apart from other savings plans is the employer match. While it’s not mandatory, some employers offer the perk of matching an employee’s contributions up to a certain amount. Be sure to check with your employer to see if they offer this benefit.

Why wouldn’t someone use a 401K?

The main reason a person wouldn’t contribute to a 401K is that their employer doesn’t offer one. If that’s the case for you, look into an Individual Retirement Account, or IRA. We’ll talk about IRAs in a future post, but the good news is, you can have both an IRA and a 401K if you’d like to diversify.

Another reason people don’t contribute to a 401K is because it reduces the amount of money they take home every paycheck. However, if you set this amount up to be withdrawn right away, you might not even miss that extra cash. We highly recommend looking for ways to include retirement savings into your monthly budget.

Why do taxes matter?

Because 401K contributions come out of your income pre-tax, you can use these contributions to lower your overall income, which potentially reduces the tax bracket you fall into. This could mean a bigger tax refund.

But the money isn’t totally tax free. Taxes on the 401K come due when you start withdrawing from the account at age 59½. Because you’re likely to make less money in retirement than you are while you’re working, you’ll likely be in a lower tax bracket when you start withdrawing your funds. And because the money isn’t taxed while it’s in the plan, any gains you make on your investment are not taxed at the time. This means that what you gain will be reinvested, leading to potential compounding monetary gains.

Protection from Creditors

Using a 401K can actually protect your retirement savings from creditors. If you run into a bad patch of luck and creditors are looking into your assets, your 401K funds are protected by the Employee Retirement Income Security Act of 1974. So, if a creditor wins a claim against you, the money in your 401K cannot be seized to repay debts.

Like we mentioned before, staying afloat in everyday life can be tricky enough, without putting money into an account that you might not use for 20, 30 or 40 years. But trust us, over time you will be thankful for every little dollar you saved and invested, even when it was tough to do.

For more savings insight, check out these tips from a few World Finance team members.