After speaking to several people about their retirement savings, I’ve realized that some people still don’t understand what 401(k) is.
401(k) is a defined contribution plan in which the employee can elect a portion of his or her pay check on a pre-tax basis towards his or her retirement savings. The name 401(k) is derived from the section the plan falls under the Internal Revenue Code.
Many people confused 401(k) as an investment and often say that his/her 401k is doing well. Some people ask me what are the returns for a 401(k). First, I give them the confused look. Then, I explain it to them. 401(k) is a tax-sheltered account (as well as an IRA), and in that account, you can designate the investment(s) of your choice (usually mutual funds available by your provider). So, the returns for your 401(k) depend on which funds you pick to invest inside the tax-sheltered account.
In layman’s terms, a 401(k) is a shell, and it is what you pick inside the shell that grows. For example, I have a 401(k) with my employer. Inside my 401(k) account, I have two mutual funds — the S&P 500 index fund and a bonds fund. So when my funds do well, I say, “My 401(k) funds (or my 401(k) portfolio) have returned 10% over the past two months.”
I hope this gives you a better understanding of what 401(k) is, and next time when someone tells you his/her 401(k) is doing great, you can point out to him/her, “It’s the funds in your 401(k) account that are doing well.”