401(k)s Made Easy: The 7 Things You Really Need to Know

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What Is a 401k?
There comes a time in most young professionals' careers when they're faced with the decision of whether to invest in a 401(k). The topic is usually brought up fleetingly during new employee orientation. Or perhaps it's mentioned in that folder you got on your first day, the one currently collecting dust on your dresser. Either way, without realizing it, you may have already given this retirement option the cold shoulder. Or maybe you did realize it and you just don't want to part with a percentage of your income today in exchange for the vague promise of seeing a bigger, better version of it years down the road.

Whatever the decision, that's up to you. But before you take a solid "yes" or "no" stance on 401(k)s, let's discuss the basics. As a wise sage once said, "An uninformed decision is no decision at all." (Just kidding. I just made that up. But, really, it's kind of true.)

So here are some basics for any of you riding that 401(k) fence:

What Is a 401(k)?

Glad you asked! Simply put, a 401(k) is a way for an employee (you!) to contribute money to an account, most often pre-tax. You can choose different plans and options to invest your money, and oftentimes, your company will contribute money to your plan as well.

What Is Matching?

Free money, free money, read all about it! Matching is the best thing that ever happened to your retirement savings. Many companies will match whatever contributions you make, up to a certain percentage. For instance, let's say they match 100 percent of your contributions up to 3 percent of your income.

And let's say you make $100,000 a year (well done!), and you contribute 3 percent, or $3,000. Your employer would match that at 100 percent, putting another $3,000 in your retirement account. So in one year, investment gains aside, your 401(k) savings would go from $3,000 to $6,000. That's a pretty killer return.

What Is Vesting?

Vesting is the little asterisk next to the contribution matching many companies offer. Not all companies require vesting. But sometimes, if a company matches your contributions, it will require you to wait a few years before you're fully vested. But what does that mean? (It has nothing to do with wardrobe requirements, thank goodness.) Quite simply, it means gaining full rights over your employer's contributions to your retirement account.

Here's an example: Let's say your company requires you to work with them for four years before you're fully vested. That means that if you quit before that time, you won't be able to keep all the money they've contributed. (Of course, all the money you've contributed is yours from Day One.) But if you quit after, say, two years, you might only be able to keep 50 percent of your company's contributions. It's a retention tactic -- and an understandable one.

What Happens to My 401(k) Contributions If I Leave My Job?

Well, you keep 'em! The question is how you keep them. One option is to cash out, although you'll be hit with taxes, as well as a 10 percent penalty for taking the money out early. Other options are to leave the money where it is (if your employer allows) and allow it to continue to grow. You could also roll it over into your new company's 401(k) or into an IRA. But no matter what, that money's still yours.

Do I Have to Pay Taxes on My 401(k)?

Years down the road, when the time comes to take out your 401(k) money, you will have to pay the standard income tax on it. But you don't have to pay taxes on the money you contribute in the year that you contribute it. In other words, if your income is $100,000 and you put $10,000 into your 401(k) this year, your taxable income come April 15 will be $90,000, not $100,000. Capisce?

Is There a Limit to How Much I Can Contribute?

Yes. As of 2013, the limit is $17,500 in a given year. However, your employer's contributions don't count toward that limit. The combined contribution limit for 2013 is $51,000. Remember, these contributions are tax-deferred; thus, the reason for the limit.

Why Should I Start Investing Now?

Our favorite question! The sooner you start contributing, the more money you'll gain in the long run -- all thanks to our little friend, compounding growth. With compounding growth, you'll earn profits on both the money you put in and, over time, on the returns from your original investments. In other words, your 401(k) money starts having babies. And then those babies have babies. And the longer you give it, the more money babies there will be. The key to lots of money babies is time. So get started on that money baby family as early as you can.

So the next time your friends quiz you on 401(k)'s, you'll get an A+. And we'll take all credit for any popularity you gain, since popularity is a little-known side effect of knowing your financial FAQs. The things we learn in a day, right?

Joanna and Johnny are the writing duo behind OurFreakingBudget.com, a personal finance blog documenting the joys, pains and realities of living on a budget. Here are a few popular posts from their blog:


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12 Comments

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jenniferetmfs

Too bad all employers don't offer their employees a 401(k) or 403(b). It's just not going to happen that way. But if you are eligible for such a plan through your employer, especially one that offers matching contributions, I would jump on it. If you leave that employer, then you should roll it over, which you can learn about at http://www.mutualfundstore.com/401k. Start saving as soon as you can, because the sooner you start, the better off you will be.

April 24 2014 at 12:49 AM Report abuse rate up rate down Reply
schmoyers

People must realize that if you leave a 401 k behind after leaving a job, your prior employer controls the funds.They may move it elsewhere. This may also happen while you are working. Some people may have it invested in a safe, steady interest bearing option, only to have it transferred a stock market only plan. This can affect people who object to the "Stock Market Casino".Finally, be aware that after you turn 7-.5 you must take fully taxable distributions. IN 2015 the "boomers" will start to turn 70., and must begin to take taxable distribuions. This will redult in a huge windfall to the government from the 401 k generation who lost pensions to 401k's. Some fo this windfall would best be directed to preserving social security and medicare for Millenials. To rely only on stock market exposed 401k "investments' could lead to generational disaste for GenXers and Millenials and the youngest boomers. r. .

December 18 2013 at 8:30 PM Report abuse rate up rate down Reply
Iselin007

napajack
You go educate yourself. There is no way that the government will deny SS payments without a civil war breaking out.


Speaking of Civil War that's my relatives in Virgina : Charlotte W married CSA General Robert E Lee's son. CSA Brigadier General WIlliams Carter W has a statue in Hanover Virginia.

December 18 2013 at 11:31 AM Report abuse +1 rate up rate down Reply
toosmart4u

Your social security account is your private account. The more you pay in the higher your monthly check. Now if you are drawing social security thank a democrat, if you want to end this fine program vote republican.

December 18 2013 at 12:06 AM Report abuse rate up rate down Reply
2 replies to toosmart4u's comment
Iselin007

It's hard to pay into SSI when the job market is unstable thanks to the jerks that sent the jobs off shore for political kickbacks and push older workers out of the remaining jobs. Lets not forget all those moochers eating up our SSI fund because it's being used as a slush fund for undocumented aliens ect.

December 18 2013 at 11:17 AM Report abuse +1 rate up rate down Reply
schmoyers

I agree that social security is a fine propgram and must be maintinatined. To rely soley on privatized 2 401 ks , mostly expose to the fotces of Wal Street could lead to disaster. That said, your contributions to social security do not wind up in a private account set up just for you. the moeny goes into some kind of a a fund that is subject ot Congressional theft. This needs to be fixed and the program itself needs to be shored up. The best way to do this is to reform the disabiltiy component and "scrap the cap" (the cap will be $117,000 in 2014, Earnings above that are not taxed at all by Social Security. A millionaire pays about a half a percent ay year to FICA, while the vast majririty pay 6.1 percent. . Make FICA a flat tax and reduce the rate for those under the cap. Also apply FICA to all sources of income, not just wages

December 18 2013 at 8:39 PM Report abuse rate up rate down Reply
paddleman1928

What happens if the gov't nationalizes all IRAs?

December 17 2013 at 11:06 PM Report abuse -1 rate up rate down Reply
Iselin007

Today there are alot of employers who have destroyed workers retirement plans. They don't want to pay so they push the older people out before the workers are vested. Too many companies have cut their costs on the worker's backs. Get old you put out a red flag an the young greedy stair climbing Adolf's force you out. There isn't many places that will let you get vested. Few jobs last 5 years anymore. Heck the vets can't even get jobs because the young Adolfs have no respect for vets or the anyone else.

December 17 2013 at 10:34 PM Report abuse +1 rate up rate down Reply
Iselin007

.Some will cut you off before your vested especially when you hit 55.Never the less the same punks have to contribute to your ACA share. The more they abuse the older generation the more they may have to pay!

December 17 2013 at 10:15 PM Report abuse -1 rate up rate down Reply
vlady1000

If your employer does no matching (like ours), normally better off putting in your Roth or IRA before the 401K

December 17 2013 at 5:33 PM Report abuse +2 rate up rate down Reply
1 reply to vlady1000's comment
Iselin007

If this market falls many of the plans will be set back years. Mergers ,aquisitions, hostile takeovers, closures, and outsourcing have little mercy on those that are victims, A lot of people never make retirement before their 66 ect. Unfortunately the job market has worsened over the last couple of decades so even if you make it to retirement your assets won't.

December 17 2013 at 10:46 PM Report abuse rate up rate down Reply
1 reply to Iselin007's comment
anwrose

BS. If you're smart enough and don't put all your eggs in one basket with your retirement planning, you stand a MUCH better chance at being able to retire at any age you so desire.
BUT, You have to work first. Many don't anymore.

December 18 2013 at 9:46 AM Report abuse rate up rate down
jenjutz

If you qualify for a Roth IRA:
Contribute the full amount that gets matched to your 401k.
Then
Contribute the max to a Roth IRA.
$5500 for those under age 50, $6000 for those 50 or older.
After that, if you want to invest more, open a regular investment account.

December 17 2013 at 3:55 PM Report abuse +2 rate up rate down Reply