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May 01, 2017 | retirement

401(k): What It Is and Why You Need It

Saving for retirement is one of those real-world mysteries: You know you should do it, but where do you start? Whether you choose a 401(k) or an individual retirement account, the trick is to start contributing now, even if it’s just a little bit every month. It could be the difference between working the conga line on a Caribbean cruise during your retirement years and just plain working.

What is a 401(k)?

It’s a private employer-sponsored retirement account that you can contribute to straight from your paycheck. 401(k) plans get their funny name from the section of the IRS tax code that authorizes them. The 401(k) equivalent for nonprofit employees is a 403(b), and the equivalent for government employees is a 457 plan.

Opting into a 401(k) or a similar employer-sponsored account is a great way to save for retirement without having to think too much about it, says Garrett Prom, founder of Prominent Financial Planning in Austin, Texas.

“It’s very automatic, and people generally don’t miss that money as much as they do if they’re writing a check,” he says.

How does it work?

Your human resources manager or employee handbook will tell you if your company offers the option to contribute to a 401(k). When you sign up, you’ll choose a percentage of your salary to chip in each pay period. It’s called “salary deferral,” since you’re essentially choosing to get paid later on, when you retire, instead of right now. Your contribution will come out of your earnings before federal and state income taxes are taken out, but it will be subject to Social Security and Medicare taxes.

Many employers offer a “match,” meaning the company will match your 401(k) contributions with the company’s own funds. It’s free money that will make your account grow faster, and companies offer it to encourage employees to save more. The best thing you can do for your retirement savings is to contribute at least the maximum percentage of your salary that your employer will match, says Steven Podnos, principal of Wealth Care LLC in Merritt Island, Florida.

“Make sure that you are salary deferring enough to get every dollar and match that you possibly can,” he says. “Because the return is spectacular.”

Say your company will match your 401(k) contributions up to 3% of your income. If you make $40,000 a year, that’s $1,200 that your employer will automatically contribute, if you put in at least that much from your own pay. So when it’s time to fill out your 401(k), paperwork, elect to contribute 3% of your earnings, and you’ll actually put away $2,400 a year in retirement savings. Keep in mind that some companies will match only 50% of your contributions, so you’d have to contribute 6% of your salary to get a 3% company match.

Where does my 401(k) money go?

Your 401(k) isn’t a static bundle that grows at the same interest rate each year like a savings account. It gets invested, and in most cases you can choose how your money is allocated: in stocks or bonds, for instance, or in a mutual fund that changes the type of investments you make based on when you plan to retire, called a target-date fund. Where your money goes — and how risky that investment is — dictates how high your rate of return will be, or how much your money will grow over time.

How do I choose where to put the money in my 401(k)?

The investment choices in your 401(k) can be overwhelming, especially if you’re new to the process. Your best bet is to read carefully through all the options you have, research on your own online and ask your plan administrator or broker for help. There are some tried-and-true avenues you can take, too.

For instance, stocks are riskier investments, so traditionally they bring you a higher rate of return. “You can’t beat the return of stocks over a long period of time,” Podnos says.

Since you’re young, you have less to lose if you invest primarily in stocks now. One option for workers in their 20s, Podnos says, is to choose a low-cost index fund that reflects the ups and downs of the S&P 500 stock market index. It’s a good idea to choose one with maintenance charges of less than 3% per year, composed mostly of stocks from all over the world so it’s diversified, he says.

When can I start using my 401(k) money?

You can withdraw money from your 401(k) without penalty when you’re 59 ½. If you dip into it before then, you’ll pay a 10% penalty. In either case, you’ll pay income tax on your contributions and interest earned based on the tax bracket you’re in when you withdraw. Since most retirees make less income after retirement and are in a lower tax bracket, waiting to withdraw is a good idea.

Also, it depends on your company’s 401(k) rules how soon you can contribute to your plan and what happens to your money when you leave. At some companies, for instance, if you leave within a year of starting in your position, you may not be able to use any of the money your employer added as part of their match.

Do I really need to save for retirement consistently this early?

Absolutely! It all comes down to compound interest. Instead of earning the same amount of interest every year, your interest rate will increase based on the amount of money in your account. So the more you put in, the more interest you’ll earn.

For instance, the 10-year average of how much the stock market has gone up is 8%. You can use this number as the likely rate of return on a 401(k), since you’ll most likely put much of your money in stocks. If you put $1,000 in a 401(k) at 8% interest and don’t touch it for 40 years, you’d have almost $22,000.

Now imagine you start with $1,000, and add $100 every month for 40 years. You’d end up with a staggering $330,000. That’s enough for a lot of Caribbean cruises. Use NerdWallet’s retirement savings calculator to play around with different retirement scenarios. That may be all the proof you need to start saving.