What is 401k, and how it works


401k is a retirement saving and investment plan offered by employers. It provides employees with a tax break on the money they contribute. The contributions are withdrawn from the employee's paycheck and invested in their fund of choice. Employees sign up for an automatic deduction from their paycheck, channeled to an individual account within his working period.



How to get 401k

It is gotten from an employer. However, not all employers offer access to 401k.

What happens to 401k in case of a job change

A rollover in the case of 401k is allowed and it usually occurs when you move your funds from one employer to another or to an individual retirement account. You can also choose to cash out your 401k in case of a job change. This action however attracts penalties such as income tax and an additional 10% withholding fee.

Benefits of 401k

  • Pre Tax contribution. Contribution to a traditional 401k plan is taken out of an employee’s paycheck before IRA takes its share, which supersizes the money you save. This makes saving a little less painful.
  • Investment growth. Once the money is in your 401k, the force protecting it from taxation remains intact. You pay no taxes or investment growth if the money remains in your account for dividends and investment gain. This implies both traditional and Roth 401ks.
  • Many employers offer a match to what you save. If you work somewhere that offers extra money into your account based on how much you contribute, the 401k perk gets all headlines in the employer match.

There are two main kinds of 401k. This includes the traditional and the Roth 401k.

The traditional 401k offers an upfront tax break on your savings, while the Roth 401k is made with after-tax dollars and does not deduct the money from that year’s taxes.

  • Lowers income tax.pre contribution of Traditional 401k can significantly lower income tax per year besides boosting your saving power.

The similarity between Roth and traditional 401k

  • They both offer tax advantages when deferring a portion of your salary into an account in your employer's retirement saving plan.
  • Both feature tax-deferred compounding of contributions made to an account.
  • Both require minimum distributions after the age of 72 with no income limits.
  • Both can be rolled over to IRA upon the retirement of leaving the job for any reason.



Differences between Roth and traditional 401k

  • Traditional 401k comes from pretax income reducing gross income reported by IRS, while Roth comes from taxable income and does not reduce the gross income reported to IRS.
  • Traditional 401k earnings and contributions are taxed at the employer's ordinary tax rate. In contrast, Roth earnings and contributions are not taxed, provided the employer makes a qualified distribution

An employer may offer a roth 401k only if they offer a traditional 401k, which may split the annual contribution between both. Once contributions are made, you may not move money between the two 401ks because of their different tax structure.

Can you lose money in a 401k 

Yes, there is no saving plan without risk. 401k funds are invested in mutual funds, target-date funds and index funds which are all traded in the stock market. They can therefore gain or lose value based on the stocks’ performance.


WriterCharles Ouko

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