Money Basics: What is a 401(k)?

Welcome to Money Basics, Yahoo Finance’s new personal finance series offering quick explanations for some of the most important terms involving your money.

Even if you’re not close to retirement age, it might be time to think about investing in a 401(k).

Named after a section of the Internal Revenue Service Code, a 401(k) lets employees save and invest a tax-deferred portion of their paycheck. Some employers offer the plan to help their workers save for retirement.

Meanwhile, some generous companies will even match a percentage of employee contributions.

For example, the software giant Oracle (ORCL) matches at a rate of 50% up to the first 6% of an employee’s contributions. Employers like this put free money toward your retirement. If your employer offers a 401(k) match and you contribute nothing, you’re saying no to this free cash.

Most 401(k) plan allow participants to invest in their choice of mutual funds, which consist of stocks, bonds, and money-market instruments.

Many people choose to invest their 401(k) in target-date funds, which automatically reset the mix of stocks, bonds, and cash equivalents in your portfolio as you get closer to retirement age.

As you get closer to retirement, your target-date fund would focus less on relatively volatile investments like stocks and instead invest more in bonds and cash equivalents.

If you’re confused about how to invest your 40(k), a representative from your plan can walk you through the process.

A 401(k) has some drawbacks, of course. When you retire, you’ll have to pay income taxes on money you withdraw. If you withdraw money before the age of 59 1/2, you may be subject to a 10% tax on top of any income tax you’ll owe (with some exceptions, including money withdrawn for higher-education expenses).

Some employers also have a time obligation on company matches called a vesting period, meaning you have to stay with the company for a certain amount of time to get your match. Moreover, you can’t simply throw as much money in your 401(k) as you’d like: The max you can contribute is currently $18,000 a year.

Despite these restrictions, a 401(k) could be your best bet for saving for retirement — particularly if your employer offers a match.

Your 401k can be a key part of your retirement savings. Understanding how a 401k works is a great step toward controlling your finances.

More from Money Basics:

• What is APR?
• What’s your net worth?
• What’s the Dow Jones?
• What’s the NASDAQ?
• What is a credit report anyway?