What is a 401(k) and how does it work?

March 29th, 2011 John Evans
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When you’re starting out, one of the most important things you can do for your financial future is to start investing in a 401(k) retirement plan.

It may seem counterintuitive to start saving for your retirement when you’re at the beginning of your professional life. Nonetheless, if you opt out of this savings opportunity you may be leaving thousands of dollars on the table. Signing up for your 401(k) as soon as possible will give you an incredible head start and may just be one of the smartest money moves you make. You’ll look back when you’re older and feel great about your decision!

What is a 401(k)?

A 401(k) is an employer-sponsored retirement plan that allows you to take a portion of your earnings – either a set dollar amount or a percentage of your salary – and move it to a tax-deferred investment account.

The money is invested at your direction into money market funds, growth funds and indexes, which will accumulate value over time. The actual work of administration and monitoring of accounts is usually outsourced to independent banks, mutual fund companies, financial service enterprises and more.

Once enrolled, your 401(k) contributions are automatically deducted from your paycheck each pay period.

What should you invest in?

Your employer will let you select your own 401(k) investments from a list of mutual funds.

Target-date or life-cycle funds are popular. With these types of funds, you fill in the year you plan to retire – for example 2045. Professional fund managers handle the rest, gradually shifting your funds from an aggressive stock-heavy portfolio early on to a conservative bond-heavy mix as you near retirement.

Benefits of a 401(k)

401(k) plans are a powerful investment tool. Some of the benefits include:

  • Matching contributions – When an employer offers a 401(k) to employees, the company often matches a portion of the money that goes into your account. Sometimes it can be as much as 50 percent. This is essentially free money or extra pay for you. Always make sure that you’re contributing enough to your 401(k) account so that you are taking advantage of these matching contributions.
  • Customization and flexibility – 401(k) plans give you the power to decide how to invest your assets. If you know you don’t have a high tolerance for risk you could opt for a higher asset allocation in low-risk investments such as short-term bonds; likewise, a young professional interested in building long-term wealth could place a heavier emphasis on equities.
  • Tax advantages – Dividend, interest and capital gains are not taxed until they are disbursed, which means you can rack up substantial savings. Plus, your account’s investment earnings will grow tax free until you withdraw. (Withdrawal restrictions may apply.)
  • Portability – One of the biggest benefits of a 401(k) account is that you can take the funds with you when you switch jobs. You’ll have the choice of either rolling over the money into your new employer’s 401(k) plan, or allocating into an Individual Retirement Account (IRA).
 
Investors should consider the investment objectives, risks, charges and expenses of the investment company carefully before investing. The prospectus contains this and other information and the investment company. You can obtain a prospectus from your financial representative. Read carefully before investing.
 
Investing in mutual funds involves risk, including possible loss of principle.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price. Stock investing involves risk including loss of principle.
 
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate to you, consult your financial advisor prior to investing.
Securities and Insurance products offered through LPL Financial and its affiliates member FINRA/SIPC. MidWestOne Bank is not a registered broker/dealer and is not affiliated with LPL Financial.
 
Not FDIC Insured
No Bank Guarantee
May Lose Value
Not a Deposit
Not Insured by any Federal Government Agency

 

John Evans

About the author

John Evans is Investment Services Manager at MidWestOne Bank. He specializes in investments and retirement planning.

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