What is a 401k?
A 401k is a tax-deferred, retirement savings plan that is sponsored by an employer.
In other words, as long as you don't withdraw the funds until age 59-1/2, you pay no income taxes on the portion of your salary you contribute to your 401k, nor on the interest earned, until you withdraw the funds.
One of the reasons 401k's are popular with employees is because in many cases employers offer to match all or part of their employees' contributions -- usually up to a certain percentage of their annual salary. However, in most cases, you will need to work for your employer a minimum number of years before you become the actual owner of the matching contributions (also known as becoming "fully vested").
How Does a 401k Work?
While there are multiple variations and exceptions, a 401k typically works like this:
- You choose where you want the funds invested (usually from a selection offered by your 401k plan).
- You designate an amount or percentage of your wages to contribute to your 401k.
- Your employer withholds your contributions from your gross wages (before taxes are taken out) and deposits the contribution -- along with any employer match -- into your 401k.
- Earnings on your 401k grow on a tax-deferred basis.
- Once you reach age 59-1/2 (or age 55 if you officially retire), you can begin making withdrawals from your 401k without penalty. Before that, you may be assessed a 10% early withdrawal penalty. In either case, your withdrawals will be subject to income taxes.
Lastly, the tax implications created by 401k plans can be very complex, so please be sure to consult with a qualified tax professional before making any decisions related to your plan.