A 401(k), named after a part of the IRS code, is one of the most common tools that people use to save for retirement. In a nutshell, a 401(k) is a special, employer-sponsored investment account that allows employees to contribute a percentage of their salary, pre-tax, to be stored away for retirement.
While this may seem a little complicated, it breaks down into three defining features:
1. Sponsored by an employer
While individuals are the ones who participate in the plan, they can not set one a 401(k) on their own -- they need their employer to do so because, by definition, these tax-deferred plans are specifically set up to help businesses encourage their employees to save for retirement.
2. Earmarked for retirement
While there are certain instances in which you can withdraw money early from your 401(k) account, they are only advisable under extreme circumstances and come with hefty penalties. By design, funds in 401(k)s are supposed to be used to help cover living expenses in your retirement years.
3. Invested in the stock market
Funds in a 401(k) can be allocated to different types of investments, including stocks, bonds, mutual funds, index funds, savings accounts, money market funds, and more. There are more than 30,000 funds available on the market, but which of those are available may depend on the 401(k) plan provider. Some plan providers offer greater flexibility than others in allowing you to choose where and how to invest your money (or how to change your investment allocation).
How should you choose funds in your 401(k)? You can learn more here.
Have you heard much about one of the increasingly popular types of investment options in 401(k)s: target-date funds? Learn more about them here.
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