How Does a 401(k) Work? (in simple terms!)

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You’ve just gotten a job. You’re excited about the new adventure & the new opportunities. Maybe you just graduated from college. Maybe this is your first “big kid” job. Whatever it is, this is a big step and you’re excited and nervous.

You show up for your first day and immediately get thrown into orientation. Health care, deductibles, W-2s, 401(k), vacation time – a lot of new things are getting thrown at you. WTF does it all mean?

Don’t be overwhelmed. I’ll break it all down for you here in simple, no-nonsense terms, starting with – how does a 401(k) work?

What is a 401(k)?

A 401(k) is a retirement savings account with a lot of perks that your regular ‘ole bank’s savings account doesn’t offer.

For one, it is tax-advantaged. This means you only pay taxes on the money once. Compare this to your bank’s savings account: When you get paid, taxes get pulled out of your paycheck. Whatever is left over is put into your savings account. Your bank will then pay you some small amount of interested on that money – which gets taxed again! Gross. We like tax-advantaged savings.

Secondly, 401(k) plans are sponsored by your employer. This means it’s easy and basically idiot-proof. You tell your company how much you want to contribute from each paycheck, they do it, it goes into an account that automatically exists just because you’re employed there, and then you start earning money. You don’t have to be responsible with your paycheck because the company pulls the money out before you even see it!

Third, many employers even match your contributions! A common benefit may be that they match up to 6% into your 401(k) account. If you put in 6% per paycheck, they put in 6% – fo’ free. Hello, free money!

Finally, your money is invested rather than stored. Your 401(k) account will have investment options that you can automatically buy into with every paycheck. These have a chance of going up (or down, unfortunately) at a much faster rate than your bank’s teensy tiny payment. Your money can GROW in a 401(k) account!

I’m young – why worry about retirement yet?

If you just graduated from college, retirement may be 30+ years away. That’s a long ways away! Even if you’re in your late 20s or early 30s, retirement may just feel like something your parents talk about. So why should you worry about it now?

Since your money is invested and has a chance to grow, investing young is where it’s at. The more time your money has to grow, the more growth you’ll see – so you’ll have more money at retirement with less effort!

Let’s take an example. Let’s say you make $35,000 per year and save 6% of that into your 401(k) account. That’s $2,100!

Let’s compare starting an account at 22 and 30. How much will it grow by the time you’re 30? 50? 65?

Assuming 7% growth per year, this is what your account may look like at different ages – and assuming you never put another penny into retirement. This is just the stock market doing its magic!

How does a 401(k) work? - Compounding Growth

By starting just 8 years earlier, your money is worth almost double what it would be if you started at the age of 30. And that’s assuming you don’t put anything in between the ages of 23-29!

Imagine how sexy that account would look if you kept up with the 6% investment for those 8 years between 22 and 30.

It’s ok to start small. Just START.

What happens if I consistently invest?

So much money happens!

Assuming you make $35,000 every year and you put in 6%, you’ll end up with over half a million dollars at retirement.

Half. A. Million. Dollars.

BUT. Let’s assume you get a 3% raise every year. That’s about standard. A 3% raise while maintaining a 6% investment into your 401(k) account will leave you with over $800k at retirement.

And don’t forget – you picked that 6% because your company matches! So what happens to your retirement account with 12% total invested (your 6% plus the company’s 6%)?


What is a 401(k) - How does Compound Growth Work

The moral of the story:

NEVER think that you’re too young to start saving. NEVER think that you don’t make enough to start saving. Starting young is important, and a little can grow into a lot over 40-something years!

Of course, you’re not guaranteed to earn 7% every year and you’re not guaranteed to get a 3% raise every year. This is just to demonstrate the possibilities!

Roth vs Traditional – WTF does that mean?

Remember up above how I mentioned that 401(k) accounts are tax-advantaged? If you don’t remember, that just means you only pay taxes on the money once.

A Roth & a Traditional 401(k) are the same idea with different tax timelines.

There is a lot of talk about taxes in this section. I agree, taxes are gross. If you want to understand the ideas in this section a little more, check out my posts on tax brackets and how US taxes work.

Traditional 401(k)

With a traditional 401(k), your money gets pulled out of your paycheck pre-tax. You won’t owe taxes on that money this year, but you’ll have to taxes on the account when you go to use the money down the road.

When you (or someone else!) does your taxes, you’ll type in that you contributed $2,100 to your traditional 401(k) account and it’ll reduce how much you have to pay in taxes (or increase how much of a return you get!). You’ll owe taxes on the initial money + whatever it grows to when you withdraw the money.

You’ll owe taxes at your retirement tax rate, not your current tax rate. Why does that matter? If you think your future tax rate may be lower, then you can get the tax benefit now!

Roth 401(k)

With a Roth 401(k), you pay taxes on the money now. The cool thing is that your $2,100 goes into the Roth account and grows a ton and, when you use it, you just take it out, tax free! So all that growth you saw above goes untaxed – Uncle Sam doesn’t take anything else.

With a lot of time, that can grow to a lot of money that the government doesn’t get to take.

Should I do a Roth or Traditional 401(k)?

This is tricky. No one knows what your income is necessarily going to do and no one knows what US tax rates are going to do.

The first question is, does your employer even offer a Roth option? If not, there’s your answer.

If they do, then you have some choices to make.

You saw above that your money will grow a ton when you’re young, so I tend to think that putting something into a Roth account is worthwhile.

I personally split my contribution to half traditional and half Roth. I’m not sure that’s right, but the internet says some kind of split is alright.

Regardless of your selection, your company’s contribution will be into a traditional account. Since I split my contribution, my 401(k) ends up 75% traditional and 25% Roth.

If this talk stresses you out, then just stick with traditional for now and start investing something. Settle into your job and, when you feel ready, talk to a professional so they can help you!

How do I pick an investment option?

That isn’t something I can advise you on, unfortunately. However, your retirement account provider will usually help you out in selecting your investments. You can click through their online options and try to figure it, select the targeted fund (a fund balancing risk & reward based on your estimated retirement date), or talk to a real-live human!

If you choose the DIY route, you can always check out some more technical tips at Investopedia.

What are the downsides of a 401(k)?

I will always invest in my company’s 401(k) but that doesn’t mean it’s a perfect system. There are a few disadvantages that you should be aware of.

  • There may be high administrative costs. The company or provider holding your money may charge you fees that are more expensive than if you invested on your own.
  • You may not have all the investment options you would like. This really is only a con for the more savvy investor, but one worth noting anyway!
  • Your money is hard to access once it’s in 401(k). If you need the money, even though it’s yours, there are penalties if you use it before retiring.

I personally think the benefits far outweigh the downsides, and so do most other people.

I hope this helped to clear up some of the mystery and complexity around 401(k) accounts! Do you have any other questions you would like answered? Feel free to comment below or email me directly!

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