How to Save for Retirement: The 401(k) Plan

Learn how to start saving for retirement now using the 401(k) plan, an employer sponsored plan with a lot of advantages.

What is a 401k?

The 401(k) plan is an employer-sponsored retirement plan in the United States.

"When you retire, you'll stop getting a paycheck, but you still need money for living expenses."

This is why it’s important to have a plan for retirement. The 401(k) plan allows you to put a portion of your income into a retirement savings account, and some employers may match part of your contribution.

The money that goes into a 401(k) is invested into a selection of mutual funds, which generally allows the balance to grow over time. What’s special about the 401(k) is that the plan is considered a “qualified” retirement plan by the IRS, making it eligible for some tax benefits.

After you retire, the balance in your retirement account is completely yours, even if your employer put money into the account. Once you are 59.5 years old, you can make withdrawals without a tax penalty, and earnings on the investments in your account are only taxed once you withdraw.

Employer Matching

One of the best benefits of a 401(k) is that most employers partially match your contributions to your 401(k) account.

Employer matching is something every employee should take advantage of, if offered. 

It’s almost like getting a raise that’s going straight into your 401(k), which you’ll be able to use post-retirement (which is when you’ll probably need extra money the most!).

Generally, employers will either match based on a certain percentage of your salary, or they may match based on your contribution up to a certain limit. In either case, contributing to a 401(k) will offer this advantage, but in the second case the employer contribution will be higher the more you contribute.

Where Do My Contributions Get Invested?

When your employer offers a 401(k), they will usually provide a selection of investment options that are overseen and managed by investment advisory firms.

Selecting Investments

You can decide one or more funds to invest your money into, with options ranging from risky high-growth investments to less risky, conservative funds. In fact, your mutual fund may be made up of a variety of investments, including large-cap, small-cap, bond, or real-estate funds.

Target-Date Funds (TDFs)

The most common type of fund used by 401(k) account holders is a target-date fund (TDF). Basically, a TDF is a mutual fund that invests your money up until a particular date, with the investments within the funds adjusting to the needs of the investor over time.

For example, if you plan on retiring in 2050, you may invest in a TDF with an end-date in 2050. Presently, most of the money in the fund will be invested in more aggressive stocks, but will over time shift to more conservative investments like bonds, etc.

Limits on 401(k) Contributions

In 2022, the maximum annual limit on your contribution to the 401(k) is $20,500, and $61,000 including employer contributions.

Once you are 50, there are is also the chance to make annual “catch up” contributions of $6500 on top of the maximum limit, for a total of $67,500 including employer contributions.

Since contributions to your 401(k) are deducted from taxable income, when you exceed your contribution limits you must report the amount you exceed by in your taxable income that year.