Simple Explanation Of A 401 K Plan

Simple Explanation of a 401K Plan


Eric Bayne

Social Security is a great safety net and helps many retired people to survive in their old age. But Social Security was never meant to be the sole source of income for retirees. It was only meant to be a supplementary source of income to a person’s pension payments and other investments. Recognizing that people were not saving their money as diligent as they perhaps should, the government began to create incentives to help them save. The 401k plan came about as a way to encourage people to save money for their retirement years by giving them certain financial incentives.

So, exactly what is a 401k plan? A 401k plan is a retirement plan for employees of companies. The company administers the plan but both employer and employee are allowed to contribute to the plan. The essential, and huge, advantage of a 401k plan is that you are able to save using pre-tax dollars. That is, the money that you earmark for the 401k is placed into the plan before it is taxed. In addition, the money is able to continually earn untaxed interest on your donations until you withdraw the money – typically at retirement. And even then, only the money that you withdraw from the fund is taxed. Presumably, since you’ll be at a lower income level when you retire, the amount of money that you will be taxed will be lower as well.


The best piece of the 401k program is that it compounds your money tax free. The compounding effect can catapult your ultimate retirement income earnings upwards of thousands or even hundreds of thousands of dollars more than if the identical investment had been placed in a normal taxed investment vehicle. Assume, for example, that you’re in the 25% tax bracket, have $1000, and you invest it in a venture that is pays you 8%. At the end of the year, you will have earned $80. But when you take out taxes, you have have only $60 left – effectively meaning that your real return was 6%, not 8% as you had hoped. If your investment vehicle had been a 401k, however, you would have paid no taxes at the end of the year. Thus you would have netted the full $80.

Now eventually, of course, you’ll have to pay taxes – but in the meantime, you have the full use of all profits derived from your investment and are able to let them compound unencumbered. If you invest more than $1000 a year in your 401k plan, which many people do and if your investments average more than 8% a year, you could realistically come out thousands of dollars ahead when your retire.

Some employers entice workers to join their company by touting their generous 401k packages. In better economic times, it was not unusual for a company to match the employee’s contribution with an equal amount of their own. So if you contributed $100 to your 401k plan, they would kick in another $100, in effect giving you a 100% gain on your money even before your investments kicked in.

In the current recessionary economy, however, those generous packages have become harder to come by. In addition, fewer companies than ever are offering pensions to their employees, making it even more important that you take control of your own retirement plans. So even if your company has a 401k plan, but no matching program in place, you should still definitely take advantage of it. When you retire, you’ll be glad you did.

Eric Bayne is writer and researcher for . At his site you’ll find articles on

401 retirement plan

, the best places to retire, as well as other articles related to retirement.

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