One of the adulting acronyms you need to know is 401(k) – but just like all those other things adults seem to mysteriously know, if you’ve never been told what a 401(k) is, it’s not obvious to figure out.
That’s for a good reason too: It’s actually named after a section of tax code. Yeah, you’re totally forgiven for thinking it’s a terrible name, because it kind of is. Naming issues aside, it’s actually a super powered way to save for retirement – and if you can use one, you totally should.
What is a 401(k)?
Let’s start with the basics. A 401(k) is a retirement savings account set up by your employer, and you can elect to contribute a portion of your salary to this account before taxes are taken out. That’s right, you don’t have to pay taxes on any money you put directly into your 401(k).
Plus, opinion time: It’s way easier to save money that you never even see. 401(k) contributions get taken out before you get your paycheck, so my bet is you won’t even notice it too much.
So wait… is that just tax-free money?!
Sadly, no. The government set up 401(k)s to help you save for retirement during your working years, and they’re not really tax-free, they’re tax-deferred. When you’re old and gray, and you withdraw money from your 401(k) to help fund your retirement fun, it’ll count as taxable income then.
The big perk is that if you’re “earning” less from your 401(k) in retirement than you’re earning at your day job right now, you’ll pay fewer taxes overall. Think about it: If you’re earning a lot now, you’re in a high-tax bracket. If you’ll withdraw less money than you’re making now to fund your retirement someday, you’ll be in a lower tax bracket. Presto manifesto, you pay fewer taxes in your lifetime.
Plus, remember the whole compounding thing
Beyond just letting you defer taxes, 401(k)s are great because they’re almost always set up as accounts you can use for investing, not just for saving. When you sign up through your employer, you’ll likely have to pick the investments you want to include in your plan.
Since you’re probably looking at decades before you retire, the money you put into your 401(k) investments will have plenty of time to grow alongside the stock market. That includes all the taxes you didn’t pay, so you’re effectively getting even more growth, and setting yourself up to actually retire someday. That’s a win.
One thing you should pay attention to when you set up your 401(k) is the cost of the investments you choose. High fees can negate a big portion of the extra growth you’d get from not paying taxes on your 401(k) contributions. Here’s a primer on those fees, which are usually called MERs.
And don’t forget the free money
Since 401(k)s are offered by employers, sometimes they’ll pump up the plan as an employee perk, and offer to match a certain percentage of your contributions to the plan.
To give you an example, your employer might say “We’ll match your 401(k) contributions up to 5 percent of your salary.” That means that if you opt to send five percent of your salary into a 401(k), they’ll give you an extra five percent of your salary, and put it directly into your account.
Can we just repeat, they will give you an extra five percent of your salary?!
That’s why you should always aim to contribute enough to get your full employer 401(k) match, if it’s available. You’re literally turning down free money if you don’t.
Can I get a 401(k) if my employer doesn’t offer it?
Well… not really. If you’re an employee at a company that doesn’t offer a 401(k), it’s not an option for you.
However, there’s one exception: If you’re self-employed, you have an option to set up a solo 401(k) to get the same tax-deferred benefits that a 401(k) offers “traditional” employees. You can even contribute more than a regular employee would, since you’re the employer and the employee all at once.
If you’re living that freelance ~lifestyle~, and you think this is a good fit for saving for your future, it’s something to look into.
Bottom line, should I use mine if it’s available?
If your employer offers a 401(k), the ability to invest your pre-tax income and watch it grow for decades is something you definitely want, and should use. If, on top of that, they offer to match part or all of your contribution? You should do everything you can to get that match.
Always take the (legal) free money. It’s a good life rule that totally applies here.
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Header image: Shutterstock
All references: https://www.irs.gov/retirement-plans/401k-plans