What exactly is a 401k?
In Human Terms: What exactly is a 401k?
Don’t you hate it when you’re hanging out with your friends or family and they use a word in the flow of conversation and you have no idea what it means? Well, after meeting with thousands of 401k participants over the years we realize that often times speaking about retirement accounts can turn into one of “those” conversations. That’s why we wanted to start a series of blogs titled In Human Terms. The goal of these posts are simple, to break down financial lingo to its simplest form allowing you to build on your financial vocabulary and create your own glossary.
With that being said, we thought there was no better place to start than asking the question, what exactly is a 401k? Many of us have one today or have utilized a 401k in the past, but there are few who know how it started, what it is, and some simple do’s and don’ts when participating in one.
How it Started
The section of the IRS code that made 401k plans possible was enacted in 1978 and was intended to provide workers with a tax break on their retirement savings. In 1980, the real birth of 401k plans occurred when a benefits consultant took the IRS code and created a simple, tax-advantaged way for employees to save for retirement. From there, different amendments have been made, but 401k plans have turned into the primary tool for Americans to save for retirement.
What it is
Unlike a Defined Benefit plan where the employer promises to pay a defined benefit to retirees who meet certain criteria, 401k plans are a type of Defined Contribution plan, where employees make automatic contributions that are deducted from their paycheck. This money, that is sometimes matched by the employer, is invested at the employees discretion into one or more funds provided within the plan. At a minimum, employees will have the ability to invest in stock, bond, and money market funds. If investments grow over time in employees accounts, the gains are left untaxed on a year-by-year basis until taken out in retirement.
Do’s and Don’ts
- If your employer provides a match, take advantage of it. If you do not know what your match is, or if your company offers one, feel free to call us (503.905.3100) right now!
- Put together an investment strategy that makes sense for your time frame and check in about every 6 months. If the words "investment strategy" don't mean anything to you, we can help you make sense of your 401k and creating a strategy. We've found that the most successful strategies come from participants who take time to set up a good plan and stick to it.
- Understand the specifics of your plan. Having a greater understanding of things like vesting schedules, loan provisions, and contribution types, can affect how successfully you invest in your plan and can save you money over time.
- Cash out when you change jobs. Ideally you do not have to cash out a 401k, especially if you are under 59 1/2. The consequences are large. For example imagine you have a $50,000 401k account and you are 40 years old. By cashing out, it’s possible that between the 10% penalty and paying federal and state taxes, your $50,000 becomes $30,000.
- Think of your 401k as a bank. 401k loans can be costly, especially if you leave your company. Before using your 401k for a down payment on a home or to take a trip, give us a call and make sure that there isn't another option.
- Put all of your money in the safest investment option. While not always the case, often times using a money market limits your long-term earning power and puts you in a position where your account is actually losing purchasing power when inflation is included.
Like most things, 401k’s are not perfect. However, if you are looking for an efficient and effective way to save for retirement, they are one of the best tools out there. We look forward to hearing from you soon, if not be on the lookout for the next In Human Terms blog!