401k Plan

If you have a 401k plan at work, it can be confusing as to what exactly you have and how it works. This page will attempt to shine a light on this rather complicated retirement investment strategy and on how you can get the most out of your 401k plan.

At its most basic level, your 401k plan is a benefit offered to you by your employer to help you save for retirement. To make this clear, this is a benefit that is part of your overall employee compensation. The employer is not doing you a favor or giving you a bonus. It should be treated no different than your salary and vacation time.

Most employers that offer a 401k plan also offer some form of matching contributions. The employer is telling you that if you choose to participate in the plan, they will also contribute to your plan. This usually comes in the form of a percentage of what you are investing every pay period up to a certain percentage of your salary.

You may hear HR tell you something like; we have a 401k plan that offers 50% up to 6%. What the HR rep is telling you is the employer will match 50% of all of your contributions up to 6 % of your salary. The 6% is not a limit of what you can contribute; it is only the limit on what your employer will match.

To make the math simple, let’s say you make $24,000 per year and are paid monthly. In addition, your 401k plan will match 50% of your contributions up to 5% of your annual salary.

Monthly Salary = $2,000 ($24,000 per year divided by 12 months)

Monthly 401k Contribution = $120 (6% of your $2,000 monthly salary)

Employer Match = $60 (50% of your contribution).

Therefore, in this scenario you will be able to save $180 per month towards your retirement. To put this another way, you are paying $120 for $180 in savings. This is no different than every time you put $120 in the bank, the bank credits your savings account $180. You would foolish to turn down the banks offer so you would be foolish to turn down your employers offer to match your retirement contributions.

The good news doesn’t stop there either. You also get a tax savings as your contributions into your 401k are not taxable. However, you will have to pay taxes when you take the money out of your savings after you retire.

In the above example your $24,000 salary will put you into a 15% tax bracket. Over the course of the year you will contribute $1,440 into your 401k plan. You will save 15% of the $1,440 or $216 as this portion of your income will not be taxable.

As you can see it makes sense to invest in a 401k plan and it is nearly mandatory to invest the full amount that will be matched by your employer. If you can invest more do so, but at least make sure you invest the portion that will be matched.