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What the Heck is a 401(k) Anyway?

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You’ve probably heard about this 401(k) thing. Maybe you spent years tuning out your parents when they talked about it at dinner parties. But now you’re starting a new job and actually have to figure out a 401(k) for yourself.

As a recent college grad who opted out of economics courses to take literature instead, I’ve been there. In an attempt to make life easier for others, here’s a primer on the 401(k).

Seriously, what is this thing?

Basically you agree to have money taken out of your salary and put it in an investment account. Hopefully, your money grows over the years and then you can take it out after you retire and live happily ever after.

(Don’t stop reading just because you have $150,000 in college loans and realize you may never be able to retire. This could help.)

401(k) accounts even give special benefits meant to encourage you to invest your money. We’ll talk about the details later, but for now just keep in your mind that investments are pre-tax and that your company might add in more money for free.

Why would I need a retirement account? (I am only 24!)

Thinking of retirement when I have thousands of dollars in college loans is not something I do often, but planning for retirement now can really help in the long run.

Your money grows exponentially over time, so a little bit now adds up to a lot later. You miss out on that chance if you start investing when you’re 40.

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John Schachter, the head of tax-prep firm Schachter & Associates in Boston agrees that people should start investing early.

Retiring at 70 may seem like a lifetime away, but Schachter made it clear it’s not.

“It is just that is not paid to you, but is paid to old you, but old you is a very nice older man or woman who is counting on you and will be here before you know it,’’ he said.

What makes a 401(k) so special?

Schachter says it is fairly low risk, especially because the money is what he called “tax favored.’’

Your 401(k) investments get taken out before taxes do (aka pre-tax). That effectively lowers your income, which means you get taxed less at the end of the year.

But don’t sweat it if you company does not offer a 401(k), there are other retirement plans that have similar perks.

Ok, but I get paid less right?

Sort of… It’s true that whatever money you contribute to your 401(k) is money you can’t spend that week. For a new grad trying to pay for rent and groceries in an expensive city, that can be a burden.

But remember you’re saving money because of the tax benefits. Plus your company probably has some sort of matching program, in which it will literally give you free money if you choose to invest in a 401(k).

This is a key point to consider while you try to decide how much money to put in your 401(k) and how much you take home to spend on Easy Mac and booze. Schachter suggests putting in the maximum amount your employer is willing to match.

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The amount varies from company to company, but let’s just say your employer will match up to 3 percent. In that case, if you invest 2 percent of your paycheck every week, your employer will also invest the same amount of money on your behalf. If you put in 3 percent, your company will do the same. But if you put in 4 percent, your company will still only invest 3 percent of your paycheck – because that’s the maximum match.

The company puts in money? And I get to keep it?

Seems too good to be true, right? Well, it is true, but it’s also a little more complicated than that.

The money you take out of your paycheck and put in a 401(k) is always yours, and you can take it with you even if you quit your company. But in order to keep the money your company has invested on your behalf, you have to be “vested.’’ Usually that happens automatically after you’ve worked somewhere for a specified period of time.

According to Schachter, this is what you should know:

“Imagine I start work at a company with a 401(k) where the company kicks in money to retirement. The company might have set things up so that if I quit shortly after joining I forfeit some company contribution. If I am vested, that means I won’t forfeit. I get to keep it even if I quit.’’

Vesting is pretty common he says because companies don’t want people just to work for a short time and then quit to collect the money the company has been investing on their behalf.

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Fine, how do I spend this money I am putting away?

“When congress created the 401(k) it created benefits, but there is a tradeoff,’’ Schachter said. “When you retire you must start taking money out and paying tax on it, the law requires a retiree to withdraw a minimum amount every year or face a penalty, you can always take more than minimum, but you cannot take less.’’

The retirement age is 70 ½ even if you are still working and that is when you have (or get) to start taking money out of your account.

You can also take out money before you retire, if needed, but be prepared to pay taxes on that money.

When you are 70 and wanting to take tropical vacations and buy second homes, don’t kick your 20-year-old self that spent all of your extra money on concert tickets and Tinder dates – start your 401(k) early.

While we’ve made the mystical 401(k) clearer, there are still plenty of decisions to be made. For more information Schachter said you can visit Vanguard or Fidelity.

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