How Does a 401k Work

In this article we are going to be looking at how a standard 401k (as opposed to a Roth 401k) works.

I’m going to go through the basic things like 401k benefits and disadvantages to give you both perspectives on 401ks and then move on to some of the more common questions and concerns that people have.

Definition of 401k

To start off let’s look at what a 401k is before we look at how a 401k works.  The first thing you need to know is that just like an IRA a 401k is an investment vehicle.  To make an analogy to physical vehicles, a 401k will hold and carry your money wherever you tell it to go.

How does a 401k work

Usually it is directed to a combination of stocks and bonds, and it can make money because of where it goes.  If you just stick money in a 401k with no direction, well it’s not going to go anywhere.

401k Benefits

There are certain 401k benefits that IRAs cannot match.  Here is a list of the top few:

  • High contribution limits: Take 2013 for example, the IRA contribution limit is $5,500 if you are under 50 years old.  In comparison the 401k limit is $17,500, which is over 3 times as much. Refer to 401k limits for more information.
  • No Income limits: You might be aware that Traditional IRA limits prevent you from deducting contributions, and Roth IRA Income limits prevent you from contributing at all sometimes.  401ks on the other hand to not have those limits.
  • Employer Match: This is a big one! Most employers offer to match your contributions up to a certain percent of your salary (usually 3-6%).  What this means is that for that first X% that you contribute you will basically be getting a 100% return on investment, which is amazing

401k Disadvantages

Of course with every investment tool there are negatives just like there are positives, and the 401k isn’t any different:

  • If you’ve read our article on IRA contribution limits you would have seen that if you or a spouse has a workplace retirement plan it can affect how much you can deduct from your taxes depending on your income level
  • Most of the properties of a 401k are decided by your workplace.  When they choose a plan you usually have pretty limited options on what you can do with it and usually has high built in fees.  An IRA on the other hand will afford you greater control which can often be valuable.

how 401k worksIs a 401k an IRA?

Do you know the answer to this now? While both the 401k and IRA are investment vehicles, they have entirely different properties.  It’s kind of like comparing a car with an 18-wheeler; they’re both good at some things and weak at others.

How Much to Contribute to 401k

One of the most common concerns is how much to contribute to a 401k.  This number will be different for everyone based on your individual situation so I encourage you to keep investing time reading and learning.  However, there is a basic recommended method that you can follow for the time being:

Step 1: Max out your employer match for your 401k

Step 2: Max out your IRA contribution (Traditional or Roth)

Step 3: If you still have money left over put it in your 401k.

Types of 401ks

Now that you have the basics we can finish off by looking at the different types of 401ks.

Traditional 401k: I’m not going to go into more detail here on it, but you can read my other article on How a Traditional 401k works.

Self Employed 401k: A self employed 401k is very similar to a traditional 401k (almost identical in fact). The purpose of a self employed 401k is to allow people to have access to a 401k even if they don’t work for anyone else.

Roth 401k: A Roth 401k works just like a traditional 401k but instead of contributing before-tax you contribute after tax.  What this allows you to do is withdraw your contributions and earnings tax free.

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