Preparing for the Future: What is a 401(k)?
Although none of us considers it when we just start working – since there’s no reason to – usually when we hit our mid 20s or early 30s, a recurring thought starts crossing our minds: What about the future?
The reality that one day we’ll want, or need, to retire is one that we face as we age. We all know there are systems in place to help people set up a retirement fund, yet many of us don’t really know much about them beyond their name – the famous 401(a) and 401(k) retirement funds.
What are the 401 funds? Are they the same as social security?
They aren’t. Social Security, when it comes to retirement, refers to a series of state-backed pensions and services meant to help the elderly. While, as mentioned, a social security plan can include a pension, said pensions are quite small – and there are plenty of doubts about the current state of social security and its long-term availability.
Instead of relying on social security, then, many Americans turn to a 401-type fund. Instead of relying on the state, 401 plans fund themselves from the person’s own money, thus giving them a guaranteed income source when they choose to retire.
What are the differences between 401(a) and 401(k) plans?
401(a) plans are only offered to government workers. They’re handled and backed by the government and, while their offers are assured, their range is limited. 401(a) pension plans are mandatory for state institutions that use them, and the money for the fund is automatically taken from your salary.
401(k) plans, on the other hand, are private-held and opt-in. Not everyone has a 401(k) plan, not everyone wants to have one, and there are as many ways to fund and manage your 401(k) as there are people in the world.
In other words, a 401(k) plan is one made to suit your own needs, creating a fund that grows as much or as little as you want it to.
How does it work? Is it a savings account?
No, a 401(k) plan isn’t the same as a savings account.
When it comes to investment plans, there are different risk levels – these risk levels usually also relate to reward levels. The riskier an investment plan is, the more money you can win from it – but also the more you can lose.
Savings accounts sit in the very extreme end of the safety side. Money in your savings account can’t disappear, or be lost in any way, barring a massive banking crash. Money in your 401(k) will actually go up and down over time, depending on the current market situation. The average earning of your money there, however, should be far higher than that of a savings account.
So a 401(k) is a risk. How risky is it?
401(k) plans are heavily regulated, and there are many rules around them to make them as safe as possible. The company handling your 401(k) cannot take risky market positions without your approval, and they’ll more often than not err on the safe side than take large risks.
In other words, 401(k) plans are managed by investment experts who are experienced in maximizing the revenue while minimizing risks.
You speak of my approval, and also said there are many ways to handle them. Does this mean I have to constantly make choices with a 401(k)?
Yes, and no. Precisely as mentioned here, there are many ways to handle them. And the most common way to do so is by simply putting money in it and letting the experts take care of the business end of things.
When you do that, you automatically agree to allow the handler of your 401(k) plan to make investments in your name following certain parameters. Those parameters vary according to the laws in your state and the specific 401(k) plan of your choosing. You can then just deposit money into it either automatically by setting it up to take an amount of money from your paycheck, or add funds to it as you can.
You can also micromanage your 401(k), potentially maximizing your profit by taking riskier positions of your choice. There are many things you can do – although that’s material for another article.
How does it work once I retire?
The specifics of how 401(k) plans work with retirement are relatively complex – as they vary not only depending on local laws, but also on how much money you have in your plan and at what age you retire. The most basic explanation is that your 401(k) plan will give you a portion of the money you have in it each month once you retire, working as a fund then.
The truth is longer, and will be explained in a separate post – as there are ways to maximize your enjoyment of your 401(k) since the amount of money you get per month, the amount of it that’s paid in taxes, and what you can do with it, will vary based on your retirement age and situation.