When you’re starting with a new employer, you typically get access to a range of benefits. When it comes to retirement plans, many companies offer employees a standard 401k. If you haven’t had a 401k before, you may be wondering what a typical one involves. Here’s a look at the standard 401k, including what it is, how it works, and the benefits it can provide.
What Is the Standard 401K?
Technically, there isn’t a “standard” 401k, as every company’s plan can differ to a degree. However, the most common offering is a traditional 401k.
A traditional 401k is an employer-sponsored retirement plan that provides employees with a selection of investment options. That can include stocks, ETFs, mutual funds, or similar types of assets, though the exact ones available do vary between retirement plans.
Employee contributions are taken directly from their paychecks, making it easy to save for retirement. Additionally, they are pre-tax. You don’t owe income taxes on the amount you send to the retirement plan immediately. Instead, you’ll pay taxes on withdrawals.
How the Standard 401K Works
A standard 401k allows employees to set money aside in a retirement-specific investment account. In many ways, it functions similarly to investing outside of a retirement account. Often, you can select from a variety of stocks, bonds, ETFs, or mutual funds. Additionally, you can usually adjust your allocations over time, though there may be limits on the types of changes you can make.
Once a contribution is made, the requested assets are acquired. Then, those investments will grow or shift over time. While most increase in value over the long-term, economic conditions that cause stock market downturns will impact 401k portfolio values. As a result, the total value of the retirement account will fluctuate, though they generally trend upward.
Once you reach retirement age, you can make withdrawals without incurring any financial penalties. However, those withdrawals do trigger tax obligations, as that money is treated as income by the IRS.
Early withdrawals are potentially an option, but they can trigger a financial penalty depending on how the funds are used. Plus, taking money out early means missing out on future gains, so it’s best to wait until your retirement whenever possible.
The Benefits of the Standard 401K
Aside from being a simple way to set money aside for retirement, a traditional 401k comes with many other benefits. As mentioned previously, contributions can come directly from your paycheck, making it easier to set money aside. Additionally, the contributions are pre-tax, so they can reduce your current tax burden.
In many cases, employers also offer contribution matches with their 401k plans. With these, the company contributes up to a certain percentage of your income, based on the amount you’re contributing. In many ways, this is functionally free money that boosts the value of your portfolio. However, as with your contributions, you do have to pay taxes when you withdraw the funds during your retirement.
If you leave your employer, you may also have options about what happens to your 401k. Some companies may allow it to remain where it is, though that isn’t universally the case. Plus, you can often roll the account over when you exit, transitioning the funds to another retirement account instead. In some cases, that means you can convert a 401k into an IRA if you prefer.
Can You Opt-Out of a Company 401K?
In most cases, opting out of an employer-sponsored 401k isn’t ideal, particularly if the company offers matching contributions. However, if you prefer to invest for retirement on your own or need to pause your contributions due to a financial hardship, that’s usually an option.
Speak with your employer’s human resources department to explore the paths you can potentially take. They’ll be able to let you know whether pausing contributions or opting out entirely is possible and can help you assess the impact of that decision. That ensures you can make a sound choice before moving forward, allowing you to ensure you don’t experience any unexpected consequences.
Do you have one of the standard 401K options through an employer and want to tell others about your experience so far? Do you wish you had access to another kind of retirement plan, or is the 401K working for you? Share your thoughts in the comments below.
Tamila McDonald has worked as a Financial Advisor for the military for past 13 years. She has taught Personal Financial classes on every subject from credit, to life insurance, as well as all other aspects of financial management. Mrs. McDonald is a former AFCPE Accredited Financial Counselor and has helped her clients to meet their short-term and long-term financial goals.