In basic terms, what is a 401(k)?
A 401k is a type of retirement account that is set up by your employer. The term 401k refers to the section of the IRS code which sets the rules for these types of retirement plans.
The employer takes the money out of your paycheck and puts the funds into the 401k prior to calculating income taxes for your income. In other words, 401k contributions reduce your taxable income. The money in the 401K is tax deferred, not tax exempt. This means that when you withdraw the money, you will have to pay tax on it.
Some employers will also match a portion of your 401k contribution. The IRS sets rules for how much the employer can contribute and the employer also has some rules for how much the company is willing to contribute.
The 401k is a vehicle for investment. In other words, it is not a specific investment. There is usually a wide selection of different types on investments that you are able to choose from such as equities, bonds, real estate investment trusts, other fixed-income offerings, foreign stocks, and more. The plan is administered by a third party, typically a brokerage.
If you withdraw money from your 401K prior to reaching age 59½ years old, there is a penalty for early withdrawal. However, there are a few exceptions to these rules such as 401k hardship withdrawals.
You are not required to participate in the the employer’s 401k plan and you can choose not to contribute to the retirement plan. It’s your choice. However since your employer will be matching some of your contributions, it’s a wise choice to make 401k contributions.