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Money

A Guide to Understanding What a 401K Actually Is

May 13, 2016

And why you should start using it now

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If you’re asking yourself what a 401k actually is, then you, my friend, are on the right track to saving for your future retired self. Although it’s a topic you and I might sometimes prefer to avoid—those retirement savings calculators can be terrifying—you’ll be doing yourself a real service if you have a solid grasp of the basics and have a plan in place.

A good old-fashioned savings account or a secret stash of cash hidden under your mattress (do people still do that?) isn’t going to do you much good in the long run. Investing your money is the key to building a substantial retirement fund, and with some sources predicting that millennials will need $1.8 million to retire, well, it’s easy to see why being strategic and smart about where you put your money—and how you invest it—really matters. Even now.

For some thoughts on 401Ks, as well as IRAs, I turned to CPA Joseph Bencivenga, a.k.a., my tax guy.

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What Is a 401K, Anyway?
It’s retirement savings contributions that are deducted from your paycheck before taxation. That means that you don’t pay any taxes on it until you begin taking money out of it (30, 40, 50 years from now). Because you’re not taxed on the deferred income, you have a nice incentive to contribute. Think about it: Less taxed income means more money for you. Aside from a rainy-day savings fund or an emergency cash fund, if you’re going to save—and, obviously, you should do everything in your control to put away at least a little every month—look beyond a traditional savings account and opt for this.

Most 401K plans, which are determined by the company, offer a spread of mutual funds composed of stocks, bonds, and money market investments for you to invest in. Usually, explains Bencivenga, an organization will offer 10 to 30 funds, and if you’re unsure which ones to choose, you should start reading up on them and educating yourself so that you can invest wisely.

Financial literacy is something that Bencivenga takes seriously and recommends reading The Wall Street Journal for starters. However, if the thought of that scares you, The Financial Diet, LearnVest, and Grow are all great resources to help you get a better grasp on the basics. Of course, if you can afford to, hiring a financial advisor who can walk you through your investments and speak to you about risky, moderate, and conservative choices is a great idea.

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401K Match and 401K Rollover
If your company offers a 401K match, and you aren’t contributing to the program, stop what you’re doing and look into it ASAP. Match means just what it sounds like: Say you decide to have $300 per paycheck deducted into your account. Your company matches that amount in a pre-determined way (it could be 50 cents on every dollar you put in, or it could be dollar for dollar). Regardless of the amount of the match—or how much you’re able to contribute each month, it’s free money, the kind that’s pretty tough to pass up.

As far as the rollover is concerned, well that’s something you’ll have to deal with if you get a new job or switch companies. If you had a 401K with Company E, and you start working at Company S, you can either roll what you’ve built up this far into Company S’ plan, or you can roll it into an IRA, aptly called a rollover IRA. The benefit of choosing the latter is that you may be able to keep your investments or even choose new ones, whereas with a 401K rollover, you’re subject to investing based on Company S’ funds. There may be some similarities across funds, so it’s worth looking into both options before deciding which one is best for you.

Wait, You Just Threw a New Word at Me—What’s an IRA?
IRA stands for Individual Retirement Account, and unlike a 401K, it’s not company-based. You choose your own funds, and you also choose which type of IRA you’d like: Traditional or Roth. The main difference has to do with when you pay taxes on the contributions. With a traditional IRA, you won’t be required to pay taxes on it until retirement—same as with 401K retirement withdrawals. A Roth IRA, on the other hand, doesn’t give you that sweet up-front tax break, but it also doesn’t tax you when you withdraw from it, either early or upon retirement. There are a few other distinctions worth understanding before you determine which one’s the right fit for your future savings plan.

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401K Versus IRA
In the face-off of retirement plans, this isn’t an easy one. Fortunately, you don’t have to choose sides if you don’t want to. You can invest in both types of retirement savings plans: a 401K and an IRA. Annual contribution amounts differ; you can put up to $18K into a 401K plan and up to $5,500 into an IRA. These numbers change once you turn 50 ($24K and $6,500, respectively).

Because you can get a substantial tax break with an IRA (just as with the 401K), it’s a smart way to sock away cash—and it’s one that really allows you to play around with various funds. If that’s something that’s of interest to you, but you don’t want to miss out on your company’s match, maybe you can contribute to both.

However, one caveat: If you’re eligible to opt into your company’s 401K, and you choose the IRA instead, you may not get the tax break you’d get if your company had no 401K option and you stick with the IRA. You can still put money in both, but the tax cut may only apply to one—worth talking to a financial advisor or accountant about if you know somebody.

One thing I hope you’ve gotten out of this is the importance of ditching the regular old savings account in favor of a plan that was designed to help build your retirement fund. That, and the memo about how crucial it is to save! The thought of retiring may be hard to grasp at this point in your life, but a failure to plan ahead may make it twice as hard to comprehend by the time you are finally ready to start thinking about it.

This post is in partnership with The Muse. The article above was originally published on The Muse.