What Is a 401(k) Plan?

You receive a thick, letter-sized package in the mail labeled “Time Sensitive Transition Information Enclosed.” Your eyes scan the words 401(k) 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 401(k) plan and why is it so important? Most Americans are not setting aside enough savings for retirement, but your employer’s 401(k) plan can be a great way to tuck money aside for the future, especially if your employer matches your contributions. And the earlier you start saving, the better off you’ll be.

Here's a general overview of 401(k) plans and how they work.

401(k) Plan Basics

A 401(k) plan gives you a place to put your money where it can grow for the future via investing. Since Social Security typically replaces about 40% of your income from when you worked, it's wise to save and invest for retirement while you're still working. The more you invest and the longer you have for your money to grow, the larger your nest egg will end up.

A 401(k) plan is offered by your employer, and they may or may not match your contributions, in full or in part. If you get an employer match (often a percentage, such as 4%), it's worth investing at least as much yourself to get that money—it's basically free cash for your retirement. 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 401(k) plan.

With a traditional 401(k), the funds you put in aren't taxed until you withdraw them in retirement (after age 59 and a half). You can withdraw these funds early, you will be charged a 10% tax penalty if you choose to do so. Some employers offer Roth 401(k)s, which are funded with taxed income; for Roth plans, you won't be taxed again in retirement.

The Importance of a Diversified 401(k)

What does it mean to diversify your 401(k)? It means using the money to invest in a healthy mix of stocks, bonds, and other financial instruments. You want to grow your investments 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 401(k) 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). And within investment categories, seek to diversify your portfolio. For example, you wouldn’t want to invest your entire 401(k) balance into one type of stock, like airlines or oil, since global events could severely depress the value of all stocks within any given category.

Get Help

If you're struggling with investing and planning for your future, consider seeking out a financial adviser. To find a good one, you can use FINRA's BrokerCheck tool. The Financial Industry Regulatory Authority (FINRA) maintains this database to help consumers find registered brokers and financial advisers.

A financial adviser can offer useful tips and information to ensure you can reach your financial goals with your investments. And as a bonus, a financial adviser might also be able to help you with personal finance basics, like creating and following a household budget. And if you're hoping to have a debt-free retirement, an adviser can help you sort through your options and make a plan. You can ask how to prioritize your debt payoff or find help deciding whether to seek debt relief.

Start Planning for Your Future Today

The more time you have to save and invest for retirement, whether that's with a 401(k) plan or an IRA you open yourself, the better off you'll be. Ask your employer about retirement plan options and prioritize setting aside a part of your paycheck to invest today, if you haven't already.