Upon entering the work force, the retirement benefits are a key incentive to lure employees to work for a company. After getting the job, an employee might ask, how does a 401k work? It is critical for employees to ask their employer about their specific 401k plan and then to ask a financial planner about their retirement options, keeping in mind their short term needs and goals as well. Employees need to be informed so they can make wise financial decisions based on their individual circumstances and goals. By the end of this article, you will be more on your way to answer the question, how does a 401k work?

So, how does a 401k work? A 401k is a retirement plan which enables a worker to save for retirement directly from their wages before taxes are taken. The savings can be invested in different assets, such as stocks, bonds, municipal bonds, mutual funds, exchange traded funds, etc. The individual worker normally will work with a financial planner or will personally determine the best breakdown of investments for the individual based on their age, life circumstances, and goals.

A 401k plan must be sponsored by an employer. The employer can be a private corporation, self-employed individual, or a government entity. Typically, government entities use a 403b plan. To participate in a company’s 401k plan, employees usually must be at least 21 years old and have completed one year of service in the company.

The employer determines the type of 401k plan they sponsor. There is a traditional 401k, Safe a Harbor 401k, and a SIMPLE 401k plan. These different plans determine the contributions the employer and the employee are eligible to make. Traditional 401k plan allows an employer to contribute a percentage of the employee’s compensation to the employee’s account, to match the employee’s contribution, or both. The employer is limited by law the amount it can match of the employee’s contribution. A Safe Harbor 401k plan allows employer to make employee contributions dollar-for-dollar up to 3 percent and then 50 cents on the dollar for contributions up to 5 percent. The SIMPLE 401k plan limits an employer to matching dollar-for-dollar contributions up to 3 percent or contributing a 2 percent of the employee’s compensation to the employee’s account.

Employees can receive distributions for their 401k accounts upon reaching the age of 59 ½. Employees can elect to receive a hardship withdrawal cause of immediate and heavy financial needs. Distributions are taxed as income received. All distributions received before the age of 59 ½ are subject to an early withdrawal penalty of 10 percent. Distributions can be taken as lump-sum distributions, roll-over distributions, or annuity.

It is important for everyone to that participates in an employer-sponsored 401k plan to be able to answer the question, how does a 401k work? Individuals ultimately are responsible for their investments and should understand what they are investing in, what advantages it provides for them, and if it meets their needs. This article hopefully gets you started on the path to answer, how does a 401k work?