What is a 401(k)?

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What is a 401(k)?

You've likely heard of a 401(k) and know that it can be an important part of your retirement. But do you know what a 401(k) is? And how you can use this account to save for your future? Read on for a quick primer on this popular savings plan.

What is a 401(k)?

A 401(k) is a savings plan offered by some employers to employees to help them save for retirement. Employers aren't required to offer a 401(k), but if yours does, it'll allow you to contribute a portion of your salary or wages up to a certain amount to an individual account. For 2015, the IRS has capped annual contributions for those under the age of 50 at $18,000; individuals age 50 or older can contribute an additional $6,000 this year.

While each 401(k) plan must adhere to IRS regulations, your employer can design its plan in a variety of different ways, including how much it will match, the vesting schedule and how your funds will be invested. Some employers may not match contributions, but there's also no legal limit on how much employers can match if they so choose.

What Are My Investment Choices?

Typically, you'll select investments from a menu of choices in your 401(k) plan. According to the Financial Industry Regulatory Authority (FINRA), the average plan has between 8 and 12 choices, which can be comprised of mutual funds (groups of investments that may include stocks, bonds and other assets), company stock, annuities (financial contracts that provide income in retirement) and more.

Also, you may be able to choose a managed account in which a professional manages investments on your behalf.

How much should I save?

How much you should contribute to your 401(k) will likely depend on your personal situation and your desired lifestyle in retirement.

Asking yourself these questions may help clarify how much you should set aside:

  • How much of my take-home pay do I need for day-to-day living expenses?
  • What are my debt obligations?
  • Do I have money in a savings account for emergencies or unexpected bills?
  • What else am I saving for?

If you still need help, considering hiring a financial advisor to create a personalized plan and savings strategy based on how you want to live in retirement.

Adam Hagerman, a Certified Financial Planner™ (CFP®) from Crofton, MD, explains why you may need an individualized approach: "Everyone's vision of retirement is different and will require a different amount of savings. If you envision yourself living in a one-bedroom cabin in South Dakota, you may not need to save much. But if you want to own two homes, buy a new car every two years and still travel the world, you need to save a lot more."

To save as much as possible in your younger years and potentially maximize investment gains, consider maxing out your 401(k) and IRA. An IRA is an individual retirement account that's separate from your employer and to which, at least for 2015, an individual under the age of 50 can contribute a maximum of $5,500 annually and an individual 50 or older can contribute a maximum of $6,500 annually. Combined with a maximum contribution to your 401(k), an individual under the age of 50 could contribute $23,500 to your retirement accounts this year and someone 50 or older could contribute $30,500.

If you're under 50 and continue investing at this rate for 30 years, and if you receive an eight percent annual return on your investment, you would have more than $2.5 million at retirement.

What are the potential tax benefits and drawbacks?

Elective deferrals - the amount you decide to contribute to a traditional 401(k) account rather than take home in your paycheck -- aren't treated as current income for federal income tax purposes, which can reduce your taxable income.

Your money can grow tax-free in a 401(k) account, so you won't owe taxes on interest, capital gains, and dividends earned on investments while you're saving for retirement. However, in retirement, you'll pay income taxes on withdrawals from a traditional 401(k) plan.

Should you run into a financial emergency and need money from your 401(k) before you retire, you may be able to tap these funds either through a loan or early withdrawal. However, you'll typically owe taxes on any previously tax-deferred income (before-tax dollars) taken from your account. In addition, you may owe penalties on early distributions.

Bottom Line

So should you invest in a 401(k) or an IRA? Use these general guidelines to help you make your decision.

With a 401(k), saving and investing for retirement is generally made easy through automatic deductions from your paycheck. If your employer offers a match, a 401(k) can be even more attractive. However, employers typically limit you to a pre-selection of investment choices.

Another factor you'll want to consider is how much you'll pay in fees for your 401(k), which can include investment fees and plan administration fees. If you do some digging into your plan (you can do this by viewing your account statements, reading your plan documents or contacting your human resources department or plan administrator), you should be able to determine these costs.

Why is knowing your fees important? The Department of Labor provides an example to show how a "1 percent difference in fees and expenses [could] reduce your account balance at retirement by 28 percent.

An IRA, which is an individual retirement account set up at a financial institution, allows you to save for retirement on a tax-free or tax-deferred basis. IRAs typically give you more investment choices than a 401(k). And, generally, there are fewer restrictions and tax consequences if you withdraw early.

About the Author:Julie Rains is a mortgage-free, debt-free personal finance writer. She began investing in her 20s soon after landing her first real job. She writes about personal finance, mortgages, investing, and related topics at various online media outlets, including her own blog Investing To Thrive. Julie is a graduate of The University of North Carolina at Chapel Hill, where she earned a Bachelor of Science in Business Administration with a concentration in Finance. In her free time, she enjoys cycling, running, hiking, and hanging out with her husband and two sons.

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