What is a 401k Plan?

You receive a thick, letter-sized package in the mail labeled “Time Sensitive Transition Information Enclosed.” Your eyes scan the words 401K plan, risk, diversify, vest, and blackout period—but you have no clue what they’re talking about. Finally, you see some terms that suggest this might have something to do with your retirement, even though you’re decades away from retiring.

So, what is a 401k plan and why is it so important? Truth is, most Americans are not setting aside enough savings for retirement, but your employer’s 401k plan (especially if they match your contributions), is a great way to tuck money aside for the future. And the earlier you start, the better off you’ll be.

The following provides a general overview of 401k plans and how they work.

What is a 401k plan? The basics

To put it succinctly, a 401K plan is essentially a savings account in which you invest your money so that you don’t have to live just on Social Security income or struggle to survive when you retire. Like all savings accounts, the longer you save and the more you put in, the more your nest egg will grow—as long as you diversify.

Typically, 401k plans are offered through your employer in lieu of a defined pension plan. Your employer may or may not match what you put into your plan each month; if they do, it’s a good idea to put in however much you can spare in order to maximize the employer match. Since people don’t typically stay with the same employer for their entire career, you’ll often “roll” your tax-sheltered balance into your next employer’s 401k plan.

The funds in your 401k are not charged taxes until you draw upon those funds at retirement. And while you can withdraw these funds early, you will be charged a 10 percent tax penalty if you choose to do so.

The importance of a diversified 401

What does it mean to diversify your 401k? It means having a healthy mixture of stocks, bonds, and other financial instruments. You want to grow your investment over a long period of time, with appreciable gains by the time you retire but without the risk that comes from investing in just one type of asset. If you instead put all of your eggs in one basket, so to speak, your 401k could be more susceptible to market volatility.

Depending on your financial needs, age, and appetite for risk, you can choose to diversify your portfolio with low volatility (bonds) or high volatility (stocks). Perhaps you want to divvy up your 401k with 70 percent stocks and 30 percent bonds. You then must diversify your portfolio within these categories. For instance, you wouldn’t want to invest your entire 401k into one type of stock, like airlines or oil, since global events could severely depress the value of all stocks within any given category.

If you want to get in control of your finances, you’ll need to roll up your sleeves and get a little dirty with financial terminology. Although it can be tough for those who typically don’t follow financial news or crunch numbers, working toward a basic understanding will help you answer the question, “What is a 401k plan?” like a pro.

If you are having a hard time understanding your investment options, or even how much to save based on your age and income, you might want to talk to a financial planning professional. Not all of them are as expensive as you might think, and there are also plenty of online investing companies that can offer options as well.

Get started planning for your future right now

Learning how to deal with debt, money, and planning for your future by funding a 401k or IRA isn’t rocket science—but it does require a little education. Our simple-to-follow guide will help you make the right decisions to move toward a better financial future. Get started today by downloading our free guide.

Learn More

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• 5 Smart Steps to a Debt-Free Retirement (Freedom Debt Relief)