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How Does a 401k Work and How Do You Start One

The 401K is a great retirement vehicle. But employers do not do a great job of telling teaching their employees how to invest in it. This article will teach you how to start your 401k retirement plan and explain to you exactly how a 401k works.

Because of the demise of pension funds, companies have moved to the 401k in order to help employees fund their retirements.   A 401k is essentially a retirement fund in which your employer matches a portion of your investments.  So you can see why this is such a popular investment vehicle.  This guide will take you step by step and teach you how to invest in your 401k.

1) Visit Your HR Office

Go to your human resources and get enrollment papers. Some companies automatically enroll you in a fund as soon as you are employed with them, but many do not. So make sure you find this out. The best way to find out if you are enrolled in a 401k is to check your paycheck.

Even if your employer does automatically enroll you in a plan as soon as you are employed with them, the plan they enroll you in is often not the optimized for your financial situation.  Employers usually enroll employees in government bonds if they do automatic 401k enrollment.  Government bonds are the safest investments in a 401k but they also gain the least.

2) See How Much Your Company Matches

Check your company’s human resource department to see how much your company matches. For the government’s 401(k) plan (called the TSP), they match 100% of your contributions, up to 5% of each paycheck. So in this example, if your the gross amount of your paycheck is $2,000, then your company will invest $100 (5%) for every $100 you invest. So if you did decide to invest 5% of your paycheck, then your $100 invested will magically turn into $200. That is essentially what a 401(k) does—it doubles your investment.

3) Analyze Your Available Fund Options

Analyze the funds available to you. Many 401(k)s will have multiple funds available for you to invest in. Depending on your risk appetite and the years until retirement, you may want to put your money in a couple of different funds. They also have lifecycle funds that takes the complications of fund-choosing away from you by automatically investing according to your years until retirement. So if you have more years until retirement, your 401(k) will be exposed to more risk so you can make bigger gains. If you are close to retiring, they will automatically adjust your fund to stable investments such as fixed income and/or government bonds.  Many of these 401k funds are managed by some of the biggest investment firms.

4) See What the Maximum Allowable Contribution Limit is

See what the maximum allowable contribution limit is on the IRS site.  The limit is changed almost yearly and is adjusted to the cost-of-living increase.  The contribution limit for a 401k in 2010 and 2011 is $16,500 for a traditional 4o1k.  The limit for a SIMPLE 401k is $11,500 for 2010 and 2011.  Keep in mind that these limits are only applicable for your portion of the contribution. Whatever your employer matches is not included in the limit.  Also, if you are the age of 50 or older, you may also elect to have a catch-up contribution on top of the IRS allowable limit.  These catch-up contributions are called elective deferral contributions.

Note: Simple 401k is a derivative of a regular 401k for smaller businesses with less than 100 employees.  You can read more about it on the IRS page concerning retirement.

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