You have heard the term 401(k) before.

You know it has to do with retirement.

You may even contribute to a 401(k), but do you fully understand it?

It’s simple to understand what it is and how it can help you.

Let me explain…

The Breakdown

A 401(k) is a company retirement plan.

The name comes from the Internal Revenue Code:
Section 401, paragraph k.

Think of it like an IRA that is affiliated with your company. An IRA is individual and private, whereas a 401(k) is through a company.

Similar to an IRA, you (usually) have the option to invest in a Traditional 401(k) or a Roth 401(k). A traditional 401(k) lets you contribute pre-tax dollars, but you will be taxed on the capital gains you earn. A Roth IRA lets you contribute post-taxed dollars, but you pay no tax on your capital gains.

The investment options will vary, depending on the retirement account provider, but you will usually be able to pick from a range of index funds and mutual funds.

With some companies you may even have more options, to include individual stocks and bonds.

Why Choose a 401(k)?

There is one main reason to choose a 401(k) over an IRA:

Free money.

Many companies will match what you put into a 401(k), up to a certain percentage. Different companies match different amounts, but if they match at all, it’s free money.

You may also want to contribute to your 401(k) in addition to an IRA since the contribution limit for a 401(k) is much higher ($17,500 compared to $5,500 for an IRA – as of 2014).

Remember: 17,500 is the maximum amount you can personally contribute, your total contributions can be higher if your company matches. The total contribution limit, including company match, is $52,000 for the year 2014.

However, if your company doesn’t offer a match and you aren’t able to contribute more than the limit for an IRA, I would suggest just sticking with your IRA since it will have more investment options.

You can also “catch up”, like you can with an IRA. Individuals over 50 can contribute an additional $5,500 per year to their 401(k) in order to help them reach their retirement goals.

Similar Plans, Different Names

A 403(b) is basically the 401(k) for organizations. 403(b) plans are only offered to public education organizations, 501(c)(3) organizations, some hospitals and self-employed ministers.

A Thrift Savings Plan (TSP) is offered to Federal employees, such as the military. Some Federal employees are offered a match and some aren’t. It depends on your position with the government.

The contribution limits and figures for 403(b) and TSP plans are the same as a 401(k).

A SEP IRA is a similar retirement account, but it is fully funded by the employer.

A Simple IRA is a company retirement plan for companies with less than 101 employees.

Contribution limits and other figures can change over the years. These numbers are current as of 2014. Get the current numbers here.

Final Words

I hope you feel a little more comfortable about 401(k) plans.

So, what should you do now?

  1. Figure out if your company has one of these plans.
  2. Contribute to your company plan if they offer a match.
  3. Contribute the maximum amount that your company will match.
  4. If your company doesn’t match, only contribute after you have maxed out your IRA.
  5. If you don’t understand something, ask questions in the comments.