How does a 401k work?

*Disclaimer: Any Information found on website is for education purposes and is not tailored to the investment needs of any specific investor. Investing involves risk, including risk of loss. 

Many employers offer their employees a retirement benefit plan known as a 401k. This type of plan can also be used if your self-employed. Now as an employee its important to know: 

  • How does a 401k work? 
  • What are pros/cons? 
  • How can I invest outside of my 401k to get to my retirement goal? 

What is a 401k? 

A 401k is a qualified plan (Acts as a tax-shelter) that allows an employee to save for retirement by contributing a percentage of their salary. There is a maximum amount you can contribute to your 401k. Any money you put in from your paycheck is pre-taxed and grows tax-deferred. By making contributions it helps to reduce your annual taxable income and the amount of tax you have to pay to uncle sam. 

In the event you are 50 years or older the IRS does allow a catchup period where you can contribute more to your 401k. 


  • Employer can contribute matching contributions up to a specific percentage of the employees contributions 
  • Funds can be withdrawn for hardships such as unemployment 
  • Funds can be withdrawn for first-time homebuyers 
  • Could also allow loans against vested balance 
  • Federal Legal Protection, Employee Retirement Security Act of 1974 (ERISA)
    • ERISA was created to protect your interests and those of your beneficiaries when you participate in a retirement plan at work. Here are some of the protections offered:
      • Disclosure of important facts about your plan’s features and funding 
      • Right to sue for benefits and breaches of fiduciary duty if the plan is mismanaged 
  • May offer free consultation with a financial advisor
  • 401k catch up period once reach 50 years old
  • Once enrolled in 401k, you will need to pick how you will invest your money from a menu of options that will be provided by employer or financial advisor
    • Do your research 


  • Limited Investment Options 
  • Early Withdrawal Fees
    • Withdrawals prior to age 59 1/2 may be subject to ordinary income tax and early withdrawal penalties

Tracking Performance

It’s also important to understand the performance of your 401k to ensure it will standup to your investment goals for retirement. 

For Example: 

Lets assume your 401k performance has been averaging about 8% per year (most average between 5% to 8%) for 20 years. 

*We will be using EZ calculator for the following calculations, use function compound interest with these settings: 


Principal amount = $0 , Monthly Deposit = $200, Period (month) = 240, Annual interest rate%=8 

Maturity value = $114,532.01

Play with the numbers based on your 401k. 

If you have any questions on how your 401k works or how to invest outside of your 401k contact us.