What is a 401k Plan?

How the 401k works – 5 Minutes that will pay you BIG

How does a 401k plan work? In this post, I am going to explain all the 401k basics. My comprehensive 401k research. All options and results disclosed to understand your options and to make the best choices to maximize your cash.

401k Definition

The Internal Revenue Service (IRS) explains the 401k definition like that:

“A 401(k) is a feature of a qualified profit-sharing plan that allows employees to contribute a portion of their wages to individual accounts. Elective salary deferrals are excluded from the employee’s taxable income (except for designated Roth deferrals.”

Why is it called 401k?

In 1978, the Congress passes the Revenue Act of 1978, which includes a provision that allows employees to avoid being taxed on a portion of income that they decide to receive as deferred compensation, rather than direct pay.

The provision becomes Internal Revenue Code Sec401(k). So far so good. And now let’s dive into the next point. Why should you participate in a 401k plan? And what are your benefits?

401k Benefits explained

We solved the 401k meaning. But the meaning alone, doesn’t really explain how the 401k works, right? And that’s what I want to disclose in the next chapter, to make sure that the 401k retirement plan will also work for you the best possible way.

Why should you start paying money into the 401k plan, and what are your real 401k benefits? Some finance blogs are talking about, that the 401k plan doesn’t bring you any value anymore. 

I raised the same question,  when my previous employer offered me a 401k plan. Should I pay some of my money into the 401k plan? Is this good for me? And if so, what are the real benefits contributing to a 401k plan?

This is where my research started. As you may already know, I am originally from Austria, and when I moved to the US I didn’t have any clue how the 401k plan works.

And if you know me by now, of course, I wanted to know what’s best for me and my beloved money. I don’t want to waste any cash. Especially not after my bloody expensive divorce. *Thank all the gods in the world

The Start of my 401k-Research

Specific 401k rules regulate all 401k basics & all 401k options. And those rules are the law. Some of those rules are pretty simple. But some of them can give you some serious headaches.

That’s how I felt when I started reading more about the 401 k plan definition. It was boring, “dry” and complicated. In fact, it was very confusing and I didn’t understand anything – even if I thought I did. There was so much blah blah blah – indeed, very annoying. 

I felt really stupid not understanding the benefits of the 401k, and finally asked myself:

If I am having a really hard time understanding and starting a 401k plan, then I am probably not alone, right?

And so I decided to start writing this comprehensive but simple guide that explains step by step how a 401k retirement plan works. A guide that explains the 401k for dummies like me! And a simple guide that goes beyond a boring 401 k plan definition.

I wanted to know the pros and cons. I wanted to understand the real 401k benefits. And I also wanted use the right plan and options to maximize my profit.

But first I had to understand the 401k Basics. And because it was so confusing, frustrating, and overwhelming, I decided to find a different way to explain this topic. With some imagination and illustration, it will be super easy to follow.

The 401k Plan is a Marriage of Cash Contributions

If you aren’t married yet, you’ll be married soon if you decide to make cash contributions to a 401k plan. Well, it’s for sure not as romantic as you might think of a real wedding.

If you are going to contribute to a 401k plan, then the typical situation is that you are employed. [If you are self-employed you will find more information about this in my upcoming report – hang in there.]

And in this case, you as an employee are going to put money into stocks, funds, trusts, etc. And at the same time, your employer is going pay an additional amount on top of your contribution.

Because both of you are going to invest money into stocks, you can see it as a cash-marriage. If you wouldn’t contribute anything, your employer wouldn’t pay anything either. And therefore it’s a 401k marriage, that will last until you get divorced [you quit, or you’ll be fired, etc.]

However. This cash marriage will bring you some benefits. And the real benefit for you as an employee is the so-called employer’s match.  That doesn’t mean that you and your employer are a good match – it just means that your employer is willing to match a specific percentage of the money you’ll invest. 

And that money, coming from your employer is the real bonus and the real benefit of participating in a 401k plan.

What is the 401k matching? 

Whatever payments you’ll make to the 401k – the employer will match a specific percentage. In other words, the employer is willing to contribute to your payments. 

How does 401k match work? 

If your employer offers a 401k plan, then this offer usually comes with a match to your 401k contributions. The amount will vary from company to company. Your HR Department should give you specific details about the benefits. 

Remember: The true benefit of participating and contributing to a 401k plan is the employer’s match.

That’s the “free” money you’ll get on top of your regular paycheck.

Let me give you a simple example, to demonstrate the 401k benefits.

401k for Dummies – the matching explained with Bob’s Example

Let me try to explain the 401k Plan with Bob’s example. Bob is starting a new job, with an annual salary of 50k. His employer also offers a 6% match. What does that mean?

Well, let’s have a closer look, and let’s understand what that 6% match means.

Bob’s annual salary before taxes is $50.000,–. He decides to contribute 6% of his money to the 401k plan.

6% from $50.000,– = $3.000,–. That’s the money he is willing to pay by himself into his 401k account.

Bob’s company notified Bob about the fact, that they are going to match 100% of his contributions. However, this 100% match is limited to a maximum of 6% of Bob’s contributions.

That means, that Bob’s annual $3.000,– contribution is going to be doubled. Because his employer is matching 100% up to his 6% payments.

A total annual amount of $6.000,– will be invested into Bob’s 401k plan. The wedding seems to pay off. Because without this cash-marriage Bob would only have $3.000,– per year in his 401k Plan. So far so good.

One thing that I want to notice. With today’s date the rules of the 401k plan regulate, that only a maximum annual amount of 18k can be paid from the employee. Lucky you are, if you have such a nice paycheck and you are able to afford that. Great job.

That being said, what’s next? Now you know that you can contribute and what it really means if your employer is willing to match up to 6%. 

What we don’t know yet, is the fact that there are two different types of 401k plans. And which 401k plan is the right one?

Alright, alright. Let’s continue with the ultimate 401k Plan for Dummies – including all 401k rules. How the 401k works & understanding all your 401k options.

Roth 401k vs. Traditional 401k

First comes first. The 401k system offers two different types of plans. Both plans are treated differently when it comes to taxes. Well, maybe not as different as you think. Because both types have one thing in common. 
You’ll always have to pay taxes for both types of plans.

Always remember: You are going to pay taxes for both plans – no matter what.

The only big difference between the two plans is at what specific time you are going to pay your taxes.

The two types of 401k plans are called TRADITIONAL & ROTH. No matter what 401k-Type you chose, your money will be locked until you reach age 59 1/2.

Both types of plans are falling under the same known 401k plan. Keep in mind & and always remember:  There are two different kinds of plans. The Traditional and the Roth.

401k Tax-Free Money Tip:
I found lot’s of websites and Ads constantly talking about a so-called 401k tax-free money. I feel this is very misleading.

Because no matter if you are going to pick the Traditional or the Roth 401k – you’ll have to pay your taxes.

Either you pay your taxes at the time you are contributing to the plan (Roth/After-Tax) or you are going to decide to pay your taxes in future. So to speak, when you’ll retire (Traditional/Pre-Tax).

In this chapter we covered the following things. 

  • What the 401k Plan is
  • How the 401k works with the cash contribution
  • The two types of 401k Plans (Traditional vs. Roth)

This is just the beginning. We just scratched the surface.  

Furthermore, it’s very important to understand the difference between the Traditional vs. the Roth 401k. I’ll also disclose the most important facts in my next chapter: Roth vs Traditional 401k – which one to pick?

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