How Does a 401k Work?

How Does a 401k Work?
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In 2014, 401(k) plans held $4.4 trillion in assets, according to the Investment Company Institute. Also known as defined contribution plans, 401(k) plans enable you to set aside a portion of your income for your retirement years.

How They Came To Be

Stable employment -- Before 401(k) plans evolved, many employers provided defined benefit plans to employees. These plans paid a specified monthly income upon retirement, and were a reward for those who gave 20 to 30 years of service to the company. These early pension plans required employers to invest and save for their employees' retirement, as they needed to have enough money to make specific payout amounts for all retired employees.

A shifting climate -- Employees now often change companies several times throughout their careers. A 30-year stint at one company is rare, so employees needed a portable plan that went with them when they changed companies. Also, with Americans enjoying longer retirement periods, defined benefit plans often translated to an expensive cost for employers.

The 401(k) plans resulted from that need to balance retirement saving options with changing career paths and increased emphasis on avoiding costly pension commitments. Employers make the plans available, but the onus is on the employees to invest and save for retirement. This makes defined contribution plans -- 401(k) plans -- more cost-effective than defined benefit plans for employers.

Your Role

When you participate in a 401(k) plan, you can decide how you want to invest your money. For example, you choose the percentage of your salary that you want to invest, and then select your investment options. If you decide you want to adjust the amounts your company withdraws from your paycheck, you're free to make this decision. You also can choose the level of risk you're comfortable with.

Plan Sponsors

Employers serve as the sponsors for 401(k) plans. They set up the plans for their employees, but they usually don't make the investment decisions or even manage the plans. Instead they hire an external company to manage the plan.

Matching contributions -- Some companies match their employees' contributions up to a certain amount. For example, your company might match up to 6 percent. If you contribute 6 percent or more of your wages, your company will add an additional 6 percent to your contributions. If you contribute less than 6 percent, the company matches only the amount you contributed. Often these employer matches vest over time, so you'll have to work for the same company for a few years to take advantage of its contributions. Your own contributions vest immediately.

Plan Administrators

When your employer's payroll service deducts your contributions from your paychecks, it sends this money, along with your employer's matching amount, to the plan administrator. Plan administrators are external firms that employers hire to manage 401(k) plans. Duties include providing and directing a variety of investment options and enforcing plan rules. Their functions include making determinations about who's eligible to participate and whether the participants are vested. They also provide reporting to applicable government agencies and plan participants.

Tax Benefits

Participation in a 401(k) plan might result in tax savings. For example, if you participate in tax-deferred plan, your employer will deduct your contributions before calculating state and federal taxes owed. Doing this lowers your taxable income and therefore your tax liability. You'll pay taxes on the money when you retire and withdraw the funds, but since retirement income is often lower than the income you earn when working, you'll likely be in a lower tax bracket. This means that you'll have a lower tax liability after retirement than you would today.