401(k): What It Is and Why You Need It

401(k), Investing
401(k): What It Is and Why You Need It

A 401(k) is a type of retirement savings account offered by an employer. It allows you to place a portion of your salary into a special account that has a specific tax benefit. The government wants to encourage you to save for retirement so they allow you to avoid some taxes if you use that money to save for retirement.

There are two types of 401(k) accounts, the Traditional, and the Roth.

  • In the Traditional, your contribution is pre-tax, meaning that your taxable income in the year of contribution is reduced. You defer paying taxes on the money until you withdraw it in retirement.
  • With the Roth 401(k), the contribution is post-tax, which means you don’t get a tax benefit in the year of contribution, but that when you withdraw the money, there are no taxes owed.

Unlike an IRA, your investment choices will be limited by whatever your employer chooses to offer. At NerdWallet, we recommend that you look for funds with the lowest fee possible (generally a well-diversified index fund) to hold in your 401(k).  If you invest in high-cost funds in a 401(k), you will usually lose more to the high costs than you can gain from the tax advantages.