What is a 401k Plan and how does it work?

What is a 401k Plan and how does it work?


What is a 401k Plan and how does it work? 

If you ever want to become a 401k millionaire, then you also know What is a 401k Plan and how does it work and you're going to need to know the ins and outs of the 401k that you're employer offers.

A 401k can be looked at as the cornerstone of investing for retirement. 

For most people, it's going to be the largest investment account in their overall portfolio. Now, unfortunately, it can be a little overwhelming to wrap your head around everything that you should know when investing in one.

Since this account is going to make up a large portion of your net worth, it's going to be important to understand it. By the end of this post, you're going to feel more comfortable and confident, with really understanding the ins and outs of investing in your 401k.

We'll cover things like,

  • 401k Benefits.
  • What a 401k is?
  • How to invest in 401k?
  • Different investment options in 401k?
  • What to look out for in 401k? and
  • The general information that you should know about investing in a 401k.
This post is going to be for anyone from a beginner who knows nothing, to someone who is more advanced that just wants to get a little refresher, just to make sure they haven't missed anything.

Today we discuss all things personal finance, investing, and financial independence.

There's a few features of a 401k that we should touch on before diving too deep.

401k Benefits

The benefits of a 401k are that after you get everything set up, the amount that you put into it is automatically taken care of every paycheck. This is a great way to automate your investing to ensure that money is being set aside on a regular basis.

You're better off having this automated so that you don't have to make the decision as to whether or not you want to invest money out of your next paycheck. You will always default to the decision of investing no matter what.

The key to growing a large portfolio is by getting into the routine of consistently depositing money into your 401k account, so this auto-invest feature is extremely helpful.

Since money is being invested on a routine schedule, you take advantage of dollar-cost averaging.

This puts you in a position to take advantage of,

  • Buying when the market is up and
  • Buying when it's down,
which in turn will help you reduce your risk of investing a ton of money when your particular investments might be a little high.

Just like with an HSA, your health savings account.

· (HSA – Health Saving Account)

Once you start investing in a 401k, it is yours forever. If you leave your current employer, then you still own what you've put into the account along with any gains on your investments.

Depending on how your employer has your 401k set you though when you stop working for that company, you might be able to leave it in that account, or they might for you to move it out of there.

Either way, I always suggest, for people who are taking the path of normal retirement, moving their money from their previous employer's 401k into an IRA that you create on your own.

What is a 401k?

401k Definition: 
401ks are a type of retirement account that is offered through your employer. It's not a requirement that an employer offers one, but when they do, it's considered a part of your benefits.

There are two types of 401ks that your employer will offer,

  • A traditional 401k and
  • A Roth 401k.
If you don't see the word Roth anywhere in your account, then just assume that it's a traditional 401k.
Some employers offer one over the other and some are going to offer both.

Now I have a post coming out where I do a deeper dive into the difference between both of them. Once that post is out, but for now, I'll give you a higher-level explanation of each one.

Traditional 401k

The first is a traditional 401k. Now if a company offers a 401k, then 99% of the time they're offering this type of 401k. 

Traditional 401k

When you invest in a traditional 401k, you're putting pre-tax money into the account, so you're not being taxed on this at all right now. You will be taxed on that money plus any gains from your investments when you go to withdraw that money in retirement in the future. 

Since you're investing with pre-tax money, your taxable income today will decrease by the amount you put in. 
  • If you have a salary of $90,000 per year; and 
  • You invest $10,000 into a traditional 401k; 
  • Then your taxable income would drop down to $80,000. 

Roth 401K

The second type of 401k that could be offered is a Roth 401K. In terms of how long 401ks have been around, a Roth 401k is fairly new since it was first introduced around 2006. Because of this, not all employers offer a traditional 401k and a Roth 401k. 
Roth 401K
The first company that I worked for out of college, only offered a traditional 401k. So I didn't have a choice at that point in time. Since then, all the companies that I've worked for have offered both a Roth and a traditional. 

With a Roth 401k, the money you put into the account has already been taxed. 
For example:-
  • If you make $90,000 per year, and 
  • You invest $10,000, into a Roth 401k, 
  • Then you'll pay taxes on that $90,000, and 
  • After then the $10,000 will be invested with those after-tax dollars. 
This means that since you already pay taxes on the money today, it will grow tax-free, and you will not have to pay any more taxes on that money, or the gains that come from it when you go to withdraw it in retirement. 

As of this year, the maximum amount that you can put into your 401k is $19,500 per year. 

Now, as time goes on, this amount will usually increase every year or every couple of years, to hopefully keep up with inflation. 

As you can see from this chart, over the years, it's increased by roughly $500 increments.

If you see this post in a year later than when it was published, then all of this info should still be relevant, except this contribution limit may have changed. 

To find out what it currently is, you could just do a quick Google search. 
    👉Withdraw Rules for 401(k) plans 

You're able to withdraw money from your 401k without paying any penalties, once you reach the age of 59 and a half and you're retired. 

Technically, you can withdraw money from your 401k at any time before then, but I highly recommend not doing this at all, unless you're someone who knows the ins and outs of it, who is pursuing financial independence. 

Because if you are not someone who is using the financial independence strategy, if you withdraw money before 59 and a half, then you'll have to take a loan from your 401k, that will need to be paid back within a certain period of time. 

If money is not paid back within that time, then you'll pay taxes and penalties. Please for the love of whatever you believe in, do not under any circumstances, ever take money from your 401k, until you're in retirement, unless you're pursuing the financial independence path, because those rules for those types of people like me are completely different. 

Don't even think about this as an option. This money is for you in retirement, not for you right now. I almost didn't even mention that this is available to you because I didn't even want to plant that seed in your head. 

But, I didn't want to knowingly withhold information from you so I figured I'd still add it in here. 

The second you cash in your investments early, your money will immediately stop growing. It cannot grow if it is not invested, even if you're loaning that money to yourself. 

401k Loan

Yes, you can take what's called a 401k loan, where you essentially loan money to yourself from your 401k, but it has to be paid back in full by a certain point in time. 

Keep in mind that there's an opportunity cost with doing it. You're giving up the returns from your investments when you sell them to create a loan for yourself. 

Do not treat your 401k like a bank, because that is not the purpose of it. 

401k Company Match

Let's talk about a company match. This is where your employer will match your contributions up to a certain %. 

So let's say, for example, your employer is going to match your contributions up to 3%, and that comes out to about $300. They're saying that if you invest $300 out of your paycheck, then they will also invest $300 for you as well. Because they're matching your $300. 

Using the same numbers, if you decided to invest 6%, then you'd be contributing $600. But since your employer is only matching 3%, then your employer is only going to invest $300 for you, since they're only going to match your contributions up to 3%. 

Looking at it from a different angle, if they're going to offer you a 3% match, and you only invest 2%, which will be $200, then they'll only match your 2% or $200. 

You're essentially leaving that 1% or $100 on the table of free money from your employer. Because of this, you always want to invest at least up to your employers match no matter what. 

The reason is, that it's an automatic guaranteed 100% return on your money invested. It's like me saying that if you give me $300 right now, then I will immediately hand you back $600. 

You'd be insane to hand be any less than $300 since I've guaranteed this to you. 

Even though they won't match you beyond that pre-determined amount, do not allow that to stop you from investing beyond that match. 

Even if you can't max yours out every year, you should still strive to increase how much you were putting aside on a regular basis. 

Do you choose the investment brokerage?

When it comes to the brokerage you use to invest your 401k, it's important to note that you don't choose that. This is something your employer automatically chooses for you. 

The way you invest in your 401k is through contributions that are pulled directly from your paychecks. 

As I mentioned before, it's an automated process that's handled without you doing anything. 

I'm not sure how your account is set up, but mine has a little slider scale, where I'm able to drag it back and forth, to choose the percentage of money, that I want to be pulled from every paycheck. 

Now I am free to adjust it whenever I want, but my goal is to never have to lower it. 

Once the money gets deposited into your account, you'll want to make sure that it's set up to auto-invest into the investments you choose, so the money doesn't just sit there, once it gets into the account. 

How much to Invest in 401k?

We'll talk through different investment options in just a minute. 
The amount you want to invest is going to be very dependent on how much you're able to invest. This is more of a personal question that only you can answer. 

For example, while I was in the process of paying off my bad debt, I wasn't able to invest as much into my 401k, because I chose to put all of my extra cash, towards getting that paid down as quickly as possible. 

During that time though, I made sure that I was at least able to invest, up to my employers match. 

Fast forward up to today, my bad debts are paid off, I have a lot more available cash, and I'm currently maxing out my 401k, so I'm putting in $1,625 per month. 

As I said before, at the very least, you should be investing in a 401k up to your employer's match. If you can do more than that, then I'd encourage you to do so. The sooner you start investing money into the account, the more time it has to grow. 

Think of your 401k like a tree, it needs to be given water on a regular basis, to grow and keep it alive. That water is the money that you put into it on a consistent basis. 

Your Investment Options

Now let's touch on some of the investment options that might be available to you. This is probably the more confusing part of the process and where a lot of people end up making a very expensive mistake, so pay attention. 

In case you didn't know, a 1% investment fee, could cost you more than $500,000 over your investment lifetime. If you need help making sure you're not paying too much in 401k fees, then check out Blooom

It's a free 401k and IRA analyzer tool, that will look through your portfolio, to make sure that you're not overpaying any fees, and will also check to see, if there are any hidden fees that you're being charged. 

Individual Stocks

The first option that you might see are Individual Stocks. These are typically available as an investment option within a 401k but, I've heard of some companies making them available. 

For example, the company that I work for is publicly traded on the stock market. So, they allow me to purchase their stock within my 401k. But that is the only individual stock that's available for me to invest in. 

There's nothing inherently wrong with purchasing single stocks because that's how you're going to grow your money. But it becomes riskier when you only own shares of a few different companies. 

It would be like going to a horse race where there are 3600 horses racing and you bet all of your money on just a few of those horses. If that horse wins, then you'll make a ton of money. 

But the odds of you picking the right horse are very low, kind of like winning the lottery. With how much money you'll be putting into your 401k over the years, you're essentially betting hundreds of thousands of dollars on one or just a few stocks. 

Target Date Retirement Funds

The next investment option that you'll probably see is Something called Target Date Funds or Target Date Retirement Funds. 

They're probably the easiest, safest and most hands-off investment that you can choose. The reason for this is because, they're set up to invest in certain things, based on the year that you plan to retire, hence the name target date because you're investing in this fund based on your target date to retire. 

So if you plan on retiring in the year 2065, then Vanguard, a company like Vanguard, has a target date fund called Target Retirement 2065. If you plan on retiring in the year 2040, then they have a target date fund called Target Retirement 2040

As you get older, you'll most likely want to start moving some of your money into bonds. Instead of you having to do this on your own, a Target Date Fund will automatically handle that for you. 

To give you an idea of what this looks like in action, in the 2065 Target Date Fund, it only holds a little less than 10% bonds. If we look at the 2040 Target Date Fund, which is expecting a retirement date that's sooner than 2065, then we'll see that it holds a little over 16% in bonds. 
If your 401k doesn't have Vanguard Target Date Funds, then some sort of target-date fund should still be available, so, just look for them.

 If you're not sure, feel free to leave a comment down below with funds that you have in your 401k, and I'll do my best to comment on every single one, to help you think through it and pick out the right ones. 

Index Funds

If you want a little more hands-on approach, then you should have an Index Fund option within your 401k. And these can be easily found by looking for an investment with one of the lowest expense ratios. 

They're cheaper because they're usually not actively managed. Because they track an index like the S&P 500, it only holds the stocks, that is a part of that index. 

With an actively managed fund, there's usually a higher expense. But we'll cover those in just a minute. If you pick an Index Fund, then you'll most likely want to also pick a bond to invest in as well because an Index Fund usually only hold stocks. 

If you want to get a little bit more familiar with what an Index Fund is, then I made a whole post explaining everything you need to know, about Index Fund Investing. 

Actively Managed Mutual Funds

Another option you'll probably see within your 401k is Actively Managed Mutual Funds. Now, these are kind of like Index Funds, but the biggest difference is that they have a fund manager, that is buying and selling stocks on a regular basis within that fund. 

Constantly buying and selling stocks can get expensive and based on history, we've seen those fund managers, aren't very good at doing it. 

The easiest way to spot an Actively Managed Mutual Fund, is by looking at the expense ratio. 
They usually cost more because, there's a team working for that fund, that is out there picking stocks. 

These are insanely expensive, so be very careful before blindly investing in one of these, just because you see some of their past returns were very high. 

A 1% fee, might not seem like a lot on the surface, but it'll cost you so much money. Over a 30 year period of 1% fee, could cost you more than $500,000. 
I cover this in more detail in the Index Fund post, I mentioned it a minute ago, so go visit that post for a deeper dive. 


The last investment option that most people want to have is a Bond. These are issued by governments and corporations and are available to be invested in. 

Think of it like you're giving each of those like a company or a government a loan. If you give them X amount of dollars by investing in that bond, then they will essentially pay you back with interest. 

Instead of you working with them one on one, you can just buy something like a bond investment that handles lending the money to the governments or corporations, and it handles paying the interest that they owe you as well. 

These are known to be a lot less volatile than something like a Stock, Index Fund or a Mutual Fund. 

Check out the menu for more resources and post lists, to help you out with all of your personal finance and investing needs. I'll see you in the next one friends, until then bye-bye and take care.