The 401(k) Basics: 5 Things You Need to Know

So, you want to know about the 401(k) investment opportunity. If you are an economic novice, it can seem like a complicated concept. In fact, however, the idea is quite simple. The 401(k) derives its name from the section of the federal tax code that governs it. They arose in the 1980s as a way of supplementing pensions for consumer retirement. While most employers used to offer a pension for their retiring employees, they now offer a 401(k), which is a way of both the employer and employee investing in the employee’s retirement. The following are five key things you should know about the 401(k) and why you should invest in one to start saving for your retirement now.

1. It is just an account, not an actual investment.  
Most people make the mistake of thinking their 401(k) itself is the investment. This is not true. The 401(k) is just the account you add money into, and from there you invest the money accordingly. Again, you have to actually invest the money once you fund your 401(k). Periodically review your investment allocation within your 401(k) to match your retirement goal and risk tolerance.

2. The money you contribute to this account is considered tax-deductible …
… unless you have a Roth 401(k). When you contribute money into your 401(k), you can deduct the contributions on your current year’s tax return. For the year 2015, employees can contribute up to $18,000 as an elective salary deferral to a 401(k) plan. For example, if you max out the 401(k) contributions in 2015 at $18,000, this amount is deductible from your gross income, therefore lowering your tax liability for the 2015 tax year.

3. If your employer matches contributions, take advantage!
If you are fortunate enough to have an employer who matches 401(k) contributions, be sure to fund at least the amount needed to get the full match. This is “free” money! Employers may match a certain percentage of your contributions; an example might be 6 percent. If this is the case with your employer, it makes sense to contribute at least 6 percent yourself so as to take advantage of the full match amount.

4. When it comes to accessing 401(k) funds, age is important.
There are a few main ages to take note of when it comes to accessing your 401(k) funds. The major one is 59½. For most accounts, accessing your 401(k) money after age 59½ will mean you can avoid paying any early withdrawal penalty fees. If your 401(k) contributions were made with pre-tax dollars, keep in mind that when you withdraw the funds, you will have to pay ordinary income taxes on that money based on your tax bracket rate in the year of withdrawal. It is important to work with a qualified financial planner and tax professional to make sure you are clear about the specifics of your 401(k) plan when it comes time to withdraw money.

5. If you are older, you can play “catch-up.”
If you are 50 years of age or older, you can make catch-up contributions to your 401(k) in addition to the regular amount allowed. In 2015, the maximum tax-free contribution is $18,000 with a catch-up contribution of $6,000, for a total of $24,000. Employees who are 50 years old or over at any time during the year are now allowed additional pre-tax catch-up contributions of up $6,000 for 2015. This means someone 50 years old or over can make a total 401(k) contribution of $24,000 in 2015.

Brittney Castro is a member of the DailyWorth Connect program. Read more about the program here.