What is a 401(k)?
If an employee signs up for a 401(k), they are essentially agreeing to have a percentage of every paycheck deposited directly into an investment account. Some employers will match the contributions, as well. This is meant to be a retirement fund.
Where is it invested?
The employee will get to choose from a number of investment options, typically mutual funds.
There are two main types of 401(k) options, the advantages are seen in tax filings.
Traditional: In a traditional 401(k), the contribution is taken from gross income – meaning the money is taken before income taxes have been deducted. As a result, the contributions are a tax deduction. When the money is withdrawn (usually in retirement) taxes will be due on the money.
Roth: With a Roth 401(k), the contribution is taken from net income – meaning the money is contributed after income taxes have been deducted. There is no tax deduction in this case, though there are no additional taxes owed when the money is withdrawn (usually in retirement).
Why is it called a 401(k)?
The name comes from the specific section of the tax code – 401(k) - that established this form of retirement plan options.
How does contributing to a 401(k) work?
The employee and employer can contribute based on dollar limits set up by the IRS.
What is the difference between a pension and a 401(k)?
A pension commits an employer to paying a set amount of money to an employee for retirement for life. A 401(k) takes the commitment off an employer, thus putting the risk of saving for retirement on the employee instead.
Is there a limit to how much one can contribute?
There are limits, though they are periodically adjusted to account for inflation. If an employer opts to contribute as well, there is an annual employee-employer contribution limit.
How does the investment aspect work?
Your contributions are invested according to the terms agreed upon by the employee and employer. How much you contribute annually, as well as the annual return and number of years until retirement, all make a difference in how much and how quickly the account will grow.
Can the funds be withdrawn early?
While it is possible to withdraw the money early, there are disadvantages, such as a 10% penalty tax which is due in addition to taxes already paid or due.
What happens in case of career changes?
If the employee no longer is employed by the company they started the 401(k) with, they can (potentially) roll the plan over to a new employer's offered plan. They also have the option of rolling it into an IRA at a bank, with a broker, or with a mutual fund company.
How is a 401(k) beneficial?
A 401(k) offers employees an opportunity to save for retirement while simultaneously easing their tax burdens. In addition, if an employer agrees to match the employees' contributions, the account will grow even more quickly.
Much of the information here comes from Investopedia.com.