I contribute to a 401k at work but I don't understand what it does and how it works.
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Tax Deffered Employee Savings Plan
Section 401(K) of the Internal Revenue Code establishes an employer sponsored retirement savings plan. A 401(k) allows an employee to save a percentage of their pretax paycheck dollars into an investment account. That means that the money you choose to take out of your paycheck is taken before taxes are calculated and hence giving you "more bang for your buck." The benefit is derived from your savings growing over the years with pre-tax money and you not paying taxes until you start to withdraw at retirement. Part of the theory is that the lump of taxes you pay at 65 (retirement) is less that the aggregate of taxes you would have paid investing in post-tax dollars. This assumes that your investment grew (compounded) at a reasonable rate and that your income tax bracket at retirement is not drastically higher than of your former working days.
Your 401(k) contribution money is put into an account and can be invested in a number of ways depending on they plan your employer has set up. Often times you have the choice of mutual fund like investments and cash/money market investments. Your employer also has the option, but not the obligation, to match a certain percent of the money that you contribute. Some lucky folks will get a dollar for dollar match while others get a small percent to no match. Many personal investment primers say that rule #1 of beginner personal investing is to make sure that you take full advantage of your employers match offer. If you do not, you are basically throwing away free money.
401(k)'s are a great idea and a great way to start saving for retirement. Your money sits, it compounds, and it grows on its own. The earlier you start saving, the more of the compounding effect you will have and the better off you will be.
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