What’s a 401(k) and the Power Behind it

By M Katie Helle, CPA – 

You may have heard the term “401(k)” if you are employed but might not understand what this means.  A 401(k) is an employer sponsored retirement savings plan.  This plan allows you as the employee to invest money from your paycheck into the plan to use when you retire.  Your contribution to the 401(k) is a pre-tax deduction which means it’s a tax savings tool – saving you money on taxes.  Each year, the Internal Revenue Service adjusts the maximum amount you can contribute based on a cost of living adjustment.  For 2019, taxpayers can contribute up to $19,000 of their earning. 

You may be asking yourself what the benefit is behind contributing to this savings plan.  Aside from obvious benefits mentioned above, there is a lot of power behind investing in a 401(k).  Many employers offer percent matching and profit sharing.  For example, an employer may offer a 5 percent match, meaning they will match your contribution up to 5 percent.  For the employer’s profit-sharing contribution, there factors such as length of employment, age and total contributions you made for the year that go into the calculation to determine your share of the profit sharing.  This all said, your employer could be offering you free money for your retirement. 

In addition to the employer’s contribution, your investment grows over time based on how you invest the money in your plan.  A young individual such as yourself might consider investing your 401(k) contributions into the plan’s stock offering as they typically offer greater gains than an investment into bonds.

Let’s break this down so you can see how fast your 401(k) can grow.    Let’s say in Year 1, you contribute $5,000 annually to your 401(k).  Your employer matches 5% as well as does an annual profit sharing to your account of $1,000.  After Year 1, your retirement account shows the balance as follows:

Based on the scenario above, you earned an extra $1,250.  This balance doesn’t reflect your investment earnings which depending on how you are invested can grow the balance even more.  Now imagine investing this amount annually for 50+ years until you retire.  The balance has the potential to grow exponentially. 

If your employer offers a 401(k) savings plan, I encourage you to learning more about the offered plan.  The earlier you start to save for retirement, the larger your balance will be.