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How it Works: Everything You Want To Know About 401k's

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A Brief History.

Named after the tax code, put in place with the Revenue Act of 1978, that allowed employees to not be taxed on deferred compensation. The 401k was created more as a happy accident than by design. As a way to promote employees to contribute to their retirement, in 1980, a benefits consultant named Ted Benna came up with the idea of offering matching contributions to their accounts. In 1981 the tax code was changed again to allow for paycheck deductions and the modern 401k was born.

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How it works

401k's are funded solely by paycheck deduction. As an employee, you agree to have a certain percentage of your paycheck go into a retirement account. The company then agrees to match your contribution up to a certain percentage. The matching contributions can be handled in a few different ways, but we will cover that in the next section. The annual contribution limit for 2022 is $20,500 or $27,000 if you are over the age of 50. Matching contributions do not count towards your contribution limits but there is a total contribution maximum of $61,000 or $67,500 if you are over 50. The investments available are determined by the employer, mutual funds being the most common, but it's not unusual to find some stocks as well, especially company stock.


The Match

There are a few options when it comes to a 401k match. I will be going over the two most common types. It's also important to know that companies are not required to make matching contributions. These options are decided when the 401k is set up, so be sure to read over your benefits carefully.

The Full Match

The full match is less common than the partial match but it is the easiest to explain. It's a dollar-for-dollar match on your contributions up to a certain max, usually 6% but not always. For instance, if you contribute 6% of your salary they will put in 6% if you put in 3% they will put in 3% if you put in 8% they still only put in 6% because that's the max.

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The Partial Match

The partial match is a little more common in the 401k world and it works like this. In this example, we are assuming a maximum of 6% matching contribution. Your employer will match 50% of your contribution up to the maximum of 6% meaning if you contribute 6% they will put in 3% if you put in 3% they will put in 1.5% and if you put in 13% they will put in 6% because you reached their maximum contribution.



As a way to retain employees, most 401k providers will put a vesting schedule in place. Meaning that the matching contribution is not yours until you have been employed for a certain number of years. The most common vesting schedule happens over a three to five-year period allowing you to keep only a portion of your employer's matching contribution until you have been there for the required time. If your 401k has a vesting schedule the detail will be provided in your company's benefit book.

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The Tax

As discussed earlier 401k's are funded by paycheck deductions. The money comes out of your paycheck before taxes do, lowering your overall taxable income. The investments inside grow tax-deferred so you are only taxed when you make a withdrawal. The amount of the withdrawal adds to your earned income for the year. Like most retirement plans there is a 10% penalty for taking distribution before age 59 1/2, but a lot of 401k's have loan provisions allowing you to take a portion out, without penalty, as long as you pay it back before you end your employment.

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Is it right for me?

In my opinion, the 401k is one of the best retirement vehicles out there. It's a very convenient way to save for retirement due to its set-it-and forget-it nature. Mixed with proper asset allocation a 401k can easily get you to your retirement goals. Make sure you are taking advantage of the matching contributions, if they are available, to not 'leave any money on the table." It should also be noted that many 401k providers offer ROTH equivalents allowing you to make after-tax contributions trading a tax deduction for tax-free income later. Some will even let you split contributions between the two. Be sure to read your benefits book carefully to know the specifics of your 401k.



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