How Does a 401k Work? The Ultimate Guide

the millennial money woman blog post "how does a 401k work"

Disclosure: This post may receive compensation from partners listed through affiliate partnerships, at no cost to you. This doesn’t influence our ratings, and the opinions are our own. Learn more here.

How does a 401k work? Here you can find everything you need to know.

In this article

The other day, my husband was asking me about 401ks and how they could help in increasing one’s net worth and if they were an effective investment tool. 

I listened to his questions and we sat down and had a brief discussion about 401ks and their advantages – as well as their disadvantages. 

That conversation gave me a light bulb moment, and that’s why I’m here today writing this post. 

Ladies, when you entered the work force, and assuming you are employed by a company offering a 401k plan, did you have “the talk” with your HR person about this mythical 401k account? 

If you actually did have a chat with someone from the administrative side of your company, did you actually follow-through with the conversation? 

As in, did you actually set up your 401k account

If you did – then congratulations! That’s fantastic.

And if you didn’t – my hope with this post is to inspire you to open up a 401k and begin contributing in order to see your investments grow as you continue your career path. 

My goal is to explore some of the key concepts of 401k’s and how these investment retirement accounts can help you on your way to making millions for retirement. 

Note, a lot of the information in this post is considered higher level and we try to avoid getting into the details – at least in this post. 

If you have specific questions about 401ks (such as Solo 401ks, 401k rollovers, and profit sharing 401ks, leave your comments in the section below or email us.

how do 401ks work

How do 401ks Work?

Think of the word “401k” as an adjective. It describes a type of investment vehicle – in this case a retirement investment vehicle. 

Many of the people I coach come into the conversation thinking that 401ks are something scary, something completely different from a regular investment vehicle. 

I’ve heard misinformed theories describing the 401k as a vehicle where your money will be locked up permanently or describing how corporations maintain control over any of the money you invest in your 401k – both theories being inaccurate.

A 401k essentially is a way for you to decide how much money will be taken out of your monthly, bi-weekly, weekly, etc. paycheck and is to be funneled toward this retirement investment account. 

You either have the choice of contributing a percentage of your salary toward your 401k or a set number amount. 

You can typically make changes to the amount of your 401k contributions when you first enroll and each quarter (March 31, June 30, September 31, December 31). 

You should be able to cancel your 401k contributions at any point in time – even if in the middle of a quarter. 

These contributions will be automatically deducted from your paycheck

It will be out of sight, out of mind – the absolute BEST way to invest and become wealthy over the long term. 

Each paycheck you receive, you’ll have your 401k contributions deducted and funneled straight into your 401k retirement account.

Pro Tip: Contributing a percentage of your annual salary toward your 401k plan may be a safer option than to elect a set number amount. 

Why? As your salary increases, the amount of money you contribute to your 401k will also increase with a percentage (it’s a percentage of whatever your annual salary is). 

On the other hand, if you elect to contribute a set dollar amount toward your 401k each year and let’s say your salary increases but you forget to increase your contributions to your 401k – that’s not the point of investing for your future. 

As your salary increases, you want to increase your contributions as well. 

Now that we have covered the basics of how money actually gets from your paycheck to your 401k, let’s cover how you can invest your hard-earned money in your 401k.

when do 401ks work best

When do 401ks Work Best?

401k’s work best when you have an employer contributing a percentage of your annual salary. 

The average percent for employer 401k related contributions lies between 3% and 6% of your annual pay. 

So, for example, if you earn $100,000 annually and you contribute to your 401k, then it’s likely that your employer will contribute up to 4% (let’s just use this average) of your annual salary – or $4,000.

What does this mean? 

If you take advantage of your 401k plan, then you’ll be adding FREE MONEY into your 401k account from your employer… think of it this way: if you see a $4,000 check addressed to you on the side of the street, would you pick it up and deposit it? 

I would hope you would – it’s free money with your name on it. All you have to do is to take advantage of the 401k option. 

Now, let’s get into some specifics regarding employer 401k contributions and how these contributions can and will be made on your – the employee’s behalf.

employer 401k contributions

Employer 401k Contribution

Generally speaking, 401k’s are set up so that employers match all or a portion of what you contribute to your 401k plan. 

This is why it’s important to contribute to your 401k plan – as much as you can possibly afford.

The reasoning here is that often times employers calculate their matching contribution based on YOUR contribution.

Although there are multiple methods for employers to calculate how to match your contributions, the two generic methods include:

1) The employer matches your contributions up to 3% (as an example) of your annual compensation.

In other words, if you earn $100,000 per year and contribution $6,000 to your 401k, then your employer (following the 3% example) would contribute an additional $3,000 on top of your $6,000. 

Is this money yours? Absolutely. 

Keep in mind that when an employer offers a 401k matching employer contribution, typically one of the requirements is that you will need to be eligible and participating in the 401k plan (in other words, you need to be contributing) in order to benefit and receive the company’s match.

If you don’t contribute to the plan, then the company is not required by law to make a matching contribution on your behalf into your 401k plan.

Like I said before, I won’t get into the details – but to caution you, sometimes there may be vesting schedules attached to 401k plans where there some requirements laid forth by the employer stating things like:

“Employee X must have worked at Company Y for 5 years in order to receive Company Y’s full 401k matching benefit.”

Why does your employer put forth such stipulations?

So that an employee having worked there for only 1 year wouldn’t take the employer’s matching contribution and run! Plain and simple. 

We can go into further detail as it relates to vesting schedules and the sort in a future post. 

Now, if you are really lucky and you work for a company that not only offers a 401k plan but also offers a 401k profit-sharing plan there is even more reason for you to take part in their 401k retirement plan program. 

What is a profit-sharing provision? 

Consider this to be another adjustive. 

Essentially, a profit-sharing provision gives your employer the ability and flexibility to make additional contributions to employee 401k accounts based on the profits a company makes each year.

Basically, you as the employee, have the chance to eat a piece of the pie through a profit-sharing provision.

There’s one caveat though: the company has the ability to decide how much (if any) of its profits it is willing to share and contribute to your 401k account.

Final Thoughts

Ultimately, investing in a 401k plan is really a question of whether you have the wiggle room in your monthly budget to invest. 

If the answer is yes, you do have extra space to invest consistently each paycheck, now it’s time to research if your employer offers a match.

If the answer is yes, stop reading and starting doing! Apply for your 401k plan now and start contributing to AT MINIMUM be eligible for the employer matching contribution.

Remember, if there is an employer match, and you don’t take advantage of this feature, it’s almost like walking away from a nice, fat check addressed to you, just lying on the side of the road.

The biggest advantage of 401(k) investing? Out of sight out of mind. 

Your investments are consistent and invested on auto-pilot. 

Part 2: How to Invest in Your 401(k)

Does your employer offer a 401(K)? If so, what is the match?

Fiona Smith
Fiona Smith
Fiona Smith is the founder of The Millennial Money Woman. She holds her Master of Science Degree in Personal Financial Planning, has advised decamillionaires for 6 years in the corporate wealth management sector and has co-founded a local non-profit community teaching financial literacy. She is the author of the personal finance book How to Get Rich from Nothing and her work is featured on Forbes and FinCon.

Leave a Comment

Your email address will not be published. Required fields are marked *

Get free access to exclusive finance tips, wealth building strategies, investing guides, and much more 👇

fiona smith the millennial money woman

Want to make more money?

Get free access to Fiona’s latest financial tips, wealth-building strategies, investing guides, millionaire planning, and much more.