What is a 401(k)?

Named after a section of the tax code, the 401(k) is the most powerful retirement tool available to the American worker.

How the Tax Shield Works

A 401(k) allows you to contribute money before taxes are taken out. For example, if you earn $5,000 a month and contribute $500 to your 401(k), the government only taxes you on $4,500. This effectively reduces your tax bill today. The money then grows tax-deferred for decades. You only pay taxes when you withdraw the money in retirement. This 'tax-deferred growth' is incredibly powerful because the money that would have gone to the IRS stays in your account, earning its own interest and dividends.

The 'Holy Grail' of the 401(k) is the Employer Match. Many companies will match your contributions dollar-for-dollar up to a certain percentage (e.g., 5%). If you earn $100,000 and contribute $5,000, your employer puts in another $5,000. This is a 100% immediate return on your investment before the money even hits the market. Failing to contribute enough to get the full match is equivalent to refusing a portion of your salary.

Common 401(k) Decisions

• Traditional vs. Roth: A Traditional 401(k) gives you a tax break now, while a Roth 401(k) lets you pay taxes now but withdraw the money entirely tax-free later.
• Choosing Funds: Avoid expensive funds with high fees. Look for a 'Total Stock Market Index' or an 'S&P 500 Index' fund.
• Vesting Schedules: Check how long you have to stay at your job before you 'own' the money your employer matched.

The Exit Strategy

If you leave your job, you have three options: leave the money where it is, roll it over into your new employer's 401(k), or roll it into an IRA. Rolling into an IRA often offers lower fees and more investment options.