The 401(k) Beginner’s Manual

Written on July 21, 2010 – 5:35 pm | by Victoria Williams

401(k) seems like a scary grown-up word that only stuffy businesspeople who work 65 hours a week and read The Wall Street Journal care about. In reality, there’s a very good chance your eligible to enroll in a 401(k) through your company and they may even offer you free money for investing.

Intrigued? You should be – we’re talking about free money here!

Let’s take a beginner’s look at the 401(k) and see how it can benefit you and your money over the next 50 years.

The Tax Advantage

A 401(k) is an investment vehicle for saving for retirement that provides tax benefits by lowering your taxed income. They are usually organized through your employer to promote retirement savings in your life.

In a Roth IRA your income is taxed first, then invested. The withdraws are tax-free.

A 401(k) works the opposite way. They take your income before it’s taxed, invest it in a fund or stock, and then it’s taxed when you withdraw your contributions in the future. A 401(k) lowers your amount of taxable income and saves you money in the long run because you have more money compounding over decades.

What Do You Invest In?

A 401(k) is just an investment vehicle, not a specific investment – just like a Roth IRA.

The type of investment depends on the employer and can range from different mutual fund options – many different stocks compacted in to one fund – to company stock. There are usually a couple of options that you can choose from depending on your risk, but just know that you won’t be able to choose your own investments for your 401(k).

The Company Match

Currently, only 48% of people invest in a 401(k). What the other 52% don’t realize is that they’re leaving free money on the table.

What sets a these retirement vehicles apart is that many companies offer to match a certain percentage of their employees 401(k) contributions.

Currently, the maximum 401(k) contribution in 2010 is $16,500 and $22,000 if you’re 50 and older.

So, for example, a company may offer a free match on 5% of a contribution. 5% of $16,500 is $825 which means if you invest $825, your company will match you and invest $825 – for free, no questions asked.

Because your money is not taxed until you withdraw, more money can take advantage of compounding now and really grow over time.

How to Get Your 401K Started

Not all companies offer a 401(k), but a good amount do. To get your 401(k) rolling, visit your HR representative at work. When you do, you’ll pick the type of investment and determine the amount of your contributions. After that, your contributions will be automatically deducted from each paycheck and you’ll be automatically investing in your sleep.

If you leave your job, the HR rep can help you roll the 401(k) in to a new retirement account so make sure to speak with them if you plan on changing jobs.

Negatives of the 401(k)

You don’t have many choices when you invest in a 401(k) and your investment may not be used as efficiently as as index fund in a Roth IRA. The 401(k) funds you have available through your employer may have high expenses or invest in areas of the market you’re not interested in.

The 401(k) is a commitment. There are a few exceptions, but your money is tied up in the account until you’re 59 1/2 – unless you pay a 10% penalty. Make sure you plan ahead and can do without the income every year. You don’t want to have to dip in to your 401(k) because you’ll disrupt the compounding and lose out over time.

Regardless, your 401(k) should be your first investment priority if your company offers a free matching contribution. Invest enough to get the match, and then max out your Roth IRA where you’ll have more choices and a more efficient opportunity to grow your money over the decades.

Do you have a 401(k) at your work? Can you share any tips for new investors about the process?

Financial News – Blog articles