Do 401k earn interest?

If you are among the millions of American workers who contribute to a 401(k) plan, you may be wondering how your retirement savings earn money. Usually, when you contribute money to a 401(k) plan, these funds are invested in various investment options that are available to employees.

401(k) plans provide interest-earning investment options that generate interest for 401(k) investors. Some of these interest-earning investment options include money market funds, corporate bonds, US Treasury bonds, and Certificates of deposits. The interest earned on the 401(k) contributions can bring substantial growth in the long term as the interest grows through compounding.

How 401(k) Plans Work

A 401(k) plan allows employees to stash away part of their paycheck for their retirement. Once an employee enrolls into the 401(k) plan, they must decide how much to contribute to the 401(k), and the employer will make payroll deductions and deposit the deferrals to each eligible employee’s 401(k). Some employers may also make matching contributions to the employee’s 401(k) up to a specific percentage of the salary as an incentive to retain top talents.

Depending on the investment options provided by each employer, the contributions will be allocated to income-earning investments. The most common investments options include stocks, mutual funds, bonds, and exchange-traded funds. Employees earn different returns on their investments depending on their asset allocation and investment options.

Interest-earning Investment Options in a 401(k) 

Some of the interest-earning investment options where 401(k) money may be invested include:

Certificates of Deposits (CDs)

CDs is an investment vehicle issued by banks, and it pays investors a certain amount of interest when they leave a fixed amount of money in the account for an agreed period, usually 6 months to 5 years. Once the agreed period matures, the investor can redeem the CD to recover the principal amount invested plus interest earnings.

Money market funds

A money market earns a return by investing in short-term security. They invest in cash and cash equivalents, which are commonly referred to as money market instruments. Money market funds give investors high liquidity and less risk exposure. Investors earn interest on money market instruments, but it may also have an element of capital appreciation.

Corporate Bonds

A corporate bond is a type of debt that companies issue to raise capital. When investors buy corporate bonds, they are essentially lending money to the company. In return, the investor earns a recurring interest during the period.

Most often, the company agrees to pay interest twice a year and repay the face value of the bond when it matures. However, corporate bonds also have default risk, and you should evaluate the bond performance prior to investing to gauge its stability.

US Treasury bonds

US Treasury bonds pay a fixed interest rate semi-annually until they mature. Usually, treasury bonds have a long maturity period of 20 to 30 years, and you can choose to hold the bond until maturity or sell before the maturity date. These bonds are considered relatively safe since they are backed by the full credit of the US Treasury, and have a low risk of default.

Store value funds

A store value fund is a bond portfolio that invests in government and corporate bonds in the short-term and immediate term. They are an ideal choice for conservative investors who want to earn interest income on their investment with minimal risk. Since they are insured, stable value funds' investors continue to earn interest while maintaining the face value of the investment, regardless of market volatility.

401(k) Asset Allocation

The performance of 401(k) accounts depends on the types of investment options you have invested in and how much money you have invested in. Different investments bring different results, and this explains why two employees in the same company may earn different returns on similar 401(k) investments.

Typically, 401(k) investment options have varied performance, and you may earn different returns depending on the performance of the market. For example, stocks have had a high rate of return compared to bonds and in a good market, your investments can generate high earnings. Growth stocks have the potential to earn a high return in the future. In comparison, debt instruments like US treasury bonds are relatively stable, but you only earn a small return every period.

Generally, you must consider your risk tolerance when deciding where to invest and how much to allocate to each investment option. If you have a few years remaining to retirement, you should focus on short-term less volatile investments that guarantee some income. However, if you have a high-risk tolerance and have more time before retirement, you can pick long-term investment options with the highest returns.