What is a 401k Plan and How Does It Work?

what is a 401k You’ve probably heard the term 401(k) a thousand times before and you might even have some of your money invested in one, but how much do you really know about it?   Perhaps you don’t even realize that you’re eligible to participate in a 401(k) plan.  Or maybe you are eligible but you don’t know anything about it and you aren’t sure if it is worthwhile. What is a 401(k) plan anyway?

In today’s article we’re going to apply the old journalist method of answering the five Ws to help explain a topic.  By the time you read the who, what, when, where, and why you’ll have all your 401(k) questions answered.

Let’s start with…

What is a 401(k) plan?

A 401(k) plan is a type of savings plan that allows you to set aside a portion of your paycheck and invest it for retirement.   Contributions are deducted from your paycheck before taxes so you get a tax break with each contribution you make.  As long as you keep the money within the 401(k) account you won’t pay any taxes until you retire and withdraw the funds.

SIDE NOTE – 401(k) isn’t the sexiest of names, and people often misinterpret it as 41K plan or a 4o1k plan.  The 401(k) got its super exciting name from the section of the Internal Revenue Code that explains it.  So the next time you decide to sit down and read the Internal Revenue Code, just turn to Section 401(k) and see for yourself.

Who Contributes to a 401(k)?

As mentioned above, 401(k) contributions come out of your paycheck.  It is YOUR money that gets invested.  Many plans also feature a company match which means your employer matches a percentage of your contributions, which allows your money to grow grow even more quickly.  For example, let’s say your employer will match 100 percent of your contributions up to five percent of your salary.  You sign up and contribute five percent and your company contributes another five percent.   That employer match is free money and a full ten percent  is deposited into your 401(k) account.

When Can You Invest in a 401(k)?

You can’t just walk into your local bank, credit union, or brokerage and open up a 401(k) for yourself.  401(k)s are employer-sponsored plans which mean that you can only invest in one if your employer offers it.  You are also limited to investing in options that your employer selected which may or may not be a good thing.  If your employer doesn’t offer a 401(k) you may be able to invest in a traditional or Roth IRA instead.

Where Does Your 401(k) Get Invested?

Investment options vary from one plan to the next, but you should expect to see a range of mutual funds that will allow you to invest in both stocks and bonds.  If you work for a publicly-owned company you may be also able to purchase company stock directly through your 401(k).  You should take some time to read up on each of the options and diversify your investments rather than keeping all of your eggs in one basket.

Why Should You Invest in a 401(k)?

Unless you’ve been living under a rock you probably already know that most people are woefully unprepared for retirement.  Too many people are saving little to no money at all.  A 401(k) plan is a great way to save because it will reduce your taxable income, the money comes out automatically before you can spend it, and if your company matches your contributions it’s like free money.

If you have access to a 401(k) plan now and aren’t signed up you should do so.  Even if you don’t think you can afford it, start small and contribute just 1 percent for now.  Then slowly raise your contributions, at least enough to receive the full employer match.

If your employer doesn’t offer a 401(k), you can still put money aside for retirement.  If you open a Roth IRA you can contribute up to $5,500 per year (or $6,500 if you are aged 50 or older).  You don’t get a tax break upfront, but you can withdraw your contributions at any time and as long as you follow the rules you will never have to pay taxes on any earnings either.

Do you contribute to a 401(k) plan?  What percentage of your salary do you invest?

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Mike is a freelance writer and blogger who specializes in finance and parenting topics. He is a dedicated husband and father of three who is obsessed with creating multiple streams of income and building wealth so he can achieve true financial freedom for his family. Like what you're reading? Subscribe to our free RSS feed and follow us on Twitter.

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  1. James says

    Thanks for the rundown on 401K’s. Good information is always appreciated. My wife’s employer offers a 401k plan that is more of a must than an option. She was told that she is required to contribute a minimum amount. I wasn’t sure if this was right. Can you be forced to contribute to a 401k?

    • says

      You can’t really be “forced” to contribute but many companies have Automatic Enrollment which means you’ll be automatically enrolled unless you choose not to participate. You usually have a set amount of time of around 90 days to undo any contributions and get refunded.

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