Saving for retirement can be confusing. You probably know that having a 401(k) is advisable, but if your eyes glaze over when presented with financial jargon, you’re not alone.
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Whether you already have a 401(k) or are thinking about opening one, it’s important to understand where your money is going — and how it’s working for you. This can help you feel more confident in your investment and may even motivate you to increase your contributions.
GOBankingRates asked two financial advisors to explain 401(k)s like they would to a 12-year-old. Keep reading to learn about this retirement savings vehicle in a manner that’s actually easy to digest.
Here’s How a 401(k) Works
“If you have a lemonade stand and make money from it, you have to give a portion to the government for taxes,” said Filip Telibasa, CFP, owner and planner at Benzina Wealth.
Putting part of your money into a 401(k) is a way to avoid paying taxes on the entire amount, at least right now, he said.
“By doing this, you avoid paying the taxes upfront and delay it way into the future when you stop working and close down the lemonade stand,” he said. “The idea is that when you no longer make money from the lemonade stand, your tax rate is much lower and therefore results in you giving less to the government.”
While the money is in your 401(k), he said it’s able to grow without having to pay annual taxes on it, creating a snowball effect that allows it to multiply faster.
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How Money in a 401(k) Grows
“The money in the 401(k) is invested,” said Samantha Mockford, CFP, associate wealth advisor at Citrine Capital. “Some of it goes to stocks, which is owning part of a company, like Roblox, Disney, Toyota, etcetera.”
These companies thrive when people buy stuff from them, causing the value of their stock to rise, she said. On the other hand, when companies don’t perform well, the value of their stock goes down.
“A 401(k) is invested in lots of companies, so that your account value will zigzag up and down over the decades,” she said. “But the general slope will be upward because, in general, companies make stuff and do stuff.”
Even if one of the companies in your portfolio doesn’t perform well or the stock market has a few rough years, lessons are generally learned and ultimately, the economy grows, she said.
She said it’s important to diversify your portfolio, so your 401(k) doesn’t rely solely on one company to perform well.
“All these little investments are like Orbeez beads,” she said. “They’re like the size of cupcake sprinkles when you get them, but when they sit in water, they all grow, and pretty soon, they can fill your bathtub.”
Employer Match
Essentially free money, many companies match employees’ 401(k) contributions to a certain percentage. For example, an employer might match your contributions to 3%.
Mockford noted that the money you receive now from your employer will actually grow to become substantially more in the future.
“Let’s say you make $1000, and your employer will match your first 3% of 401(k) savings — you put in $30, and they’ll put in $30,” she said. “You’re getting more than $30 free. A 15-year-old who saves $30 in a 401(k) earning 7% interest per year will see it grow to $1,407 when they retire.”
If you’re offered this benefit, it’s important to contribute up to the employer match, at minimum. Doing anything less is basically saying you don’t want the extra money offered to you for your golden years.
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Experts Explained 401k(s) Like I’m 12 — Here’s What I Learned
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