When students become young professionals, they soon realize adulthood requires a lot of financial planning. Most are quick to learn about managing their money. But one question stumps many recent grads: what is a 401k?

What is a 401k?

What is a 401k exactly? Most recent grads don’t know.

A 401k is a private employer-sponsored retirement account that an employee may contribute to straight from their paycheck. With a 401k, workers can save and invest part of their paycheck before taxes are removed. In a 401k, employees can control how their money is invested. Typical investments include mutual funds that contain stocks, bonds, and money market investments.

Employees choose a percentage of their salary to contribute to a 401k. This is called “salary deferral,” because this money that comes out of their check will be paid back to them with interest when they retire. Another incentive to sign up is that many employers match the employee’s contribution to their 401k with company funds.

And, Why Should I Have One?

Many people sign up for a 401k because the employer match provides essentially free money that will be available in retirement. Financial planners suggest that an employee should contribute the maximum percentage allowed by their company to take full advantage of this incentive. 401k employer matches, which are chosen by each company, can vary from 50 percent to 100 percent.

401k Advice for Recent Grads

Before enrolling in a 401k program, recent grads should understand that there are penalties for withdrawing from their 401k before age 59 ½. According to 401k rules, anyone who withdraws money early from their 401k must pay an IRS early withdrawal penalty of 10 percent. For this reason, it is not worthwhile to withdraw from a retirement account in order to receive immediate cash.

Recent grads should also understand that it is important for them to personalize their own 401k. The amount contributed can depend on factors like life expectancy and how much money a person feels comfortable living on during their retirement. In personal financial planning, it’s best to set a retirement goal at the outset to help determine how much will be contributed to a 401k.

If you still need help with understanding what is a 401k, DeFreitas & Minsky can help.

At DeFreitas & Minsky, we specialize in all aspects of tax returns on Long Island. If you need financial advice or would like any more assistance, don’t hesitate to call us at 516.746.6322.