Do you find it hard to pay attention when someone explains the finer details of vested scheduling or elective deferrals? You’re not alone. It's easy to let all that fiduciary talk overwhelm you when trying to determine if you should contribute to your company's 401(k) plan. However, understanding employee benefits is critical if you are to intelligently evaluate job offers and negotiate compensation.
All 401(k) plans have certain elements in common. Here are the basics to help you understand how a 401(k) can help you save for retirement.
What is a 401(k) plan?
A 401(k) plan lets you set aside a certain amount of your salary and/or bonus as savings that will become available when you retire. The main advantage of 401(k) plans over other retirement plans is that they're portable, so you can take most or all of your funds with you if you change jobs. Employers choose whether or not to offer a 401(k) plan as part of their benefits package.
Types of 401(k) plans
Employers can choose from a number of 401(k) plans to offer their employees. The most common are the traditional, SIMPLE and Safe Harbor 401(k)s. In these plans, you and your employer can make pretax contributions. The money is taxed only when you draw from it during retirement, and there are penalties for withdrawing money before retirement. The frameworks for different types of plans and vesting are complicated, however, and you should double-check the rules for a particular plan before taking any action.
Types of 401(k) contributions
There are two types of contributions that can be made to a 401(k) plan. They include:
- Nonelective contributions — This means your employer has committed to contributing to your retirement account whether or not you do.
- Elective contributions — This refers to funds that you choose to contribute toward your 401(k) retirement account.
Many 401(k) plans offer some sort of matching, or employer contribution to the plan, when you contribute. Often, an employer will stipulate that you must remain with the company for a certain time period before the funds fully vest and become completely yours. If you leave the company earlier, you forfeit all or part of the employer contribution. Of course, your own contributions to any plan are always fully vested.
The amount your employer matches is based on its discretion and policy. Companies that do match 401(k) contributions typically use a formula. A common example is for the employer to match 50 cents for every dollar you contribute up to a certain percentage of your salary.
Therefore, if you save 2 percent of your salary, your employer will contribute another 1 percent of your salary. But if you save 6 percent of your salary, your employer's match is 3 percent of your salary. In a way, you could view this as "free" money you receive just by saving! Again, check your individual plan for exact details.
Read the fine print
401(k) plans are a popular way to help employees save for retirement today. But individual plans vary, so it's important to fully understand the fine print of your employer's plan to take full advantage of it. The Internal Revenue Service and U.S. Department of Labor provide additional resources workers can consult for information on 401(k) plans. Also be sure to speak with your accountant or financial adviser about any questions you have.