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Retirement Planning

How does a 401K work?

Learn some of the basics about the inner workings of your 401(k) savings plan so that you can make proactive decisions about where and how your money is invested.

401K Basics

According to the Congressional Research Service, 42 percent of workers who are offered a defined contribution plan such as a 401(k) plan, choose to participate in it.1 Unfortunately, understanding 401(k) plans and how they work can be somewhat of a mystery. You may be a diligent participant making regular contributions via payroll deductions, but what do you really know about what makes your 401(k) tick?

Sponsors and administrators

First of all, it's important to understand that your employer typically does not invest your money for you. However, your employer serves as your plan's sponsor. The role of the sponsor is to take your payroll deduction, deposit it into an account on your behalf, and then select another company (called the investment manager), to manage the plan and invest your money. Your plan's investment manager can be an insurance company, a brokerage firm, or a mutual fund company. If you're unsure about yours, just ask your company's HR or payroll representative. Your 401(k) account statement can also provide you with information on your plan's investment manager.

How your money is invested

Once your employer sends your deduction to the investment manager, it is invested. However, where it is invested is often up to you. Typically, most 401(k) plans will allow you to select from several different mutual funds in which to invest your money. Having a variety of options can be a good thing, but for some people, making the decision about where to put their hard-earned dollars can be somewhat of a daunting task. After all, everyone wants to put their money where it will benefit them the most.

In many cases, investment managers will offer “groups” of mutual funds that are based on specific retirement goals and individual risk tolerance. This can make it a bit easier to decide where to direct your contributions. For example, your plan's investment manager might offer a choice of funds for people who have long-range retirement goals and don't plan on retiring for another 30 plus years. Or, they might offer a group of funds for individuals who are less than 10 years away from retirement.

The more you know, the better

It is important to be proactive and learn as much as you can about the different types of funds that are offered in your plan. You can do this by taking advantage of employer-provided information and by asking questions. Most investment managers have interactive websites that you can use to not only review your 401(k) holdings, but to learn more about your investment choices. If you find that you require more help regarding your investment decisions, seek the help of a financial advisor who can help you determine what's best for meeting your retirement objectives and goals. You can also find a lot of 401(k) topics on the IRS Website, and read more about saving for retirement.





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