A 401k is an investment plan that allows an employee to invest a percentage of his or her income for retirement. The employer chooses and manages the plan, but allows the employee to decide how the money will be invested. Usually, the funds are put into a variety of mutual funds or even company stock, and they can be re-allocated at any time by the employee. If the mutual funds lose money, the value of the 401k can drop. Potentially, the entire amount in a 401k can disappear, but if the money is invested in safe funds, then this is an unlikely situation. However, during the recent economic downturn in the United States, many people lost their accumulated investment in 401k; some even lost their entire retirement funds.
How It Works
When you decide to start investing in a 401k, you agree to allow your employer to remove a designated amount of money from your pay each time. This money is taken off the top in a manner known as deferment, because you defer that amount to go directly into your 401k account. The money in your 401k draws interest while it is in the account, and it can be withdrawn without penalty once you retire from the company. Your retirement age should be at least 59 ½ years. If you withdraw money early from a 401k, you pay income tax on that amount in addition to a penalty fee.
Besides allowing you to save money for retirement, a 401k gives you tax savings at the time you are investing the money.Any amount you have deferred to go directly into the 401k is exempted from income tax, saving you a lot of money on your tax bill. A Roth 401k even lets you make qualified withdrawals after age 59 ½ tax-free, so that the money you deferred into your 401k is actually never taxed.
The cost of a 401k is variable, based on many factors. The amount of your income is the first factor. When you decide to set up a 401k through your employer, you will designate a percentage of your income to go directly into the account each time you are paid. You have to decide how much you want to invest. Sometimes, employers will match your investment up to a certain amount, essentially letting you double the amount you invest into your 401k.
Once you have worked for a company for a designated amount of time, anywhere from three months to one year, you can usually start investing in a 401k. The earlier you start, the more money you are likely to have available to withdraw when you retire.
Your employer will offer you a 401k plan. Other than your employer, no one else can make this investment plan available to you since it is deducted from the salary automatically.