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Wednesday, February 21, 2024

What is a 401(k)?

What is a 401(k)?

Key takeaways

  • The 401(k) is a common workplace retirement solution offered by many private-sector employers.
  • It provides employees with the opportunity to invest for retirement in a tax-advantaged way.
  • It can serve as a pillar of building wealth.

09.15.2023

There are many ways to save money and protect your future, but one of the most popular options is to save in a 401(k) plan. Read on to learn more about 401(k) plans and how they work.

What is a 401(k) plan?

The 401(k) plan is a workplace retirement plan.1 It allows workers to defer a certain portion of their wages into a retirement account, which they can then invest for the future. In return, workers get certain tax advantages both in the short term and the long term.

How a 401(k) works

When someone is hired by a company that offers a 401(k), they’re able to contribute a certain dollar amount or percentage of their wages to the account. In most cases, the funds they contribute are pre-tax, meaning they help to reduce their taxable income in the current year.

Once the funds have been deposited into the 401(k), the worker can choose from a menu of investment options offered by the plan. 401(k) investment options often include target-date funds and other types of investment funds.

Then comes another tax benefit of the 401(k). Once the money has been contributed to the account and invested, it’s able to grow tax-deferred as long as it remains in the account. In other words, a worker won’t be subject to income or capital gains taxes as they would on earnings in a taxable brokerage account.

Finally, once the worker is ready to retire, they can withdraw money from their 401(k) plan. Because the contributions were made pre-tax, income taxes will be owed on the distributions.

Note: There are also plans that offer Roth 401(k) contributions, which have after-tax contributions and tax-free withdrawals during retirement. We’ll dive further into those accounts in a later section.

Read more: 401(k) calculator: Are your savings on track?

How do you invest in a 401(k)?

Because a 401(k) is a workplace retirement plan, the only way to invest is by working for a company that offers one. The good news is that roughly 68% of private employers offer defined contribution retirement plans like the 401(k), meaning most private sectors workers will have access to one.2

In addition to working for a company that offers this type of plan, there may be other restrictions. For example, a company may require that you be a full-time employee or work there for a certain amount of time before you’re able to participate in the plan.

If you don’t have access to a 401(k) or another workplace retirement plan, you still have tax-advantaged options to save for retirement. One of your best options is to open an individual retirement account (IRA), which offers some of the same benefits as a 401(k).

Contribution limits

The IRS sets limits on the amount workers can contribute to their 401(k) plans. The 2023 contribution limit is $22,500. There’s an additional catch-up contribution of $6,500 for workers ages 50 and older. Therefore, older workers can contribute a total of $29,000 per year.

It’s up to each worker how they choose to spread their contributions throughout the year. If allowed under the plan, some people may choose to frontload their contributions to give their investments more time to grow. However, it’s more common for people to contribute an equal amount each pay period, often as a percentage of their wages. Maxing out the $22,500 contribution limit might look like:

  • $1,875 per monthly paycheck
  • $937.50 per twice-monthly paycheck
  • $865.38 per bi-weekly paycheck

401(k) employer matching

In addition to the money that workers contribute to their 401(k) accounts, employers can also contribute. In fact, 95% of employers contribute to their employee’s retirement accounts, a statistic that hasn’t really changed in the past five years.3

Regardless of how much you contribute to your 401(k), it’s worth contributing at least enough to get the full match your employer offers. After all, it’s part of your total compensation.

There are a couple of different ways a 401(k) match can work:

Partial match

One common type of employer match is a partial match. In this case, an employer might agree to match 50% of an employee’s contributions up to 6% of that employee’s wages. Someone who contributed at least 6% of their own wages to their 401(k) would receive an employer match of 3%.

Dollar-for-dollar matching (100% match)

Another way employers may match their employees’ contributions is with a dollar-for-dollar match. In other words, the company agrees to fully match a worker’s contributions up to a certain percentage of their wages. For example, a company might match 100% of contributions up to 3% of each employee’s wages.

As you can see, our examples for the partial match and dollar-for-dollar match net the employee the same amount of money. But in the partial match situation, the employee must contribute twice as much to get the same amount from their employer.

Non-elective contribution

A final type of contribution some employers make is a non-elective (or profit sharing) contribution. Employees don’t have to contribute anything to get this contribution from their employer. Instead, the company contributes this amount automatically, usually as a percentage of an employee’s wages.

Read more: How to understand your 401(k) plan

Withdrawing from your 401(k)

There are special rules about how and when you can withdraw money from your 401(k). Generally speaking, you can only withdraw money if one of the following has happened:

  • You die, become disabled, or otherwise leave your job
  • The plan terminates and isn’t replaced with another
  • You reach age 59½
  • You experience a financial hardship

Because a 401(k) is a retirement plan, they’re designed to hold your money until you retire and use the funds to replace your income. The situations above describe other situations in general when someone may withdraw money without a penalty from their 401(k) account. 

Can I withdraw early?

The IRS tries to discourage people from taking money from their 401(k) plans early. Because of that, there’s a 10% penalty on most withdrawals made before age 59½. And that’s on top of the ordinary income taxes you’ll already pay on your distributions. However, there are some exceptions that would allow someone to withdraw money early without paying the 10% additional tax. Those situations include:

  • Becoming disabled
  • Taking a series of substantially equal periodic payments for life
  • Leaving your job during or after the year you turn 55
  • Transferring amounts to someone else under a qualified domestic relations order
  • Paying for medical care up to the allowable deductible amount

Required minimum distribution

The IRS requires workers who participated in a 401(k) plan to begin taking withdrawals once they reach age 73 if they are no longer working. Because contributions to these accounts are made pre-tax, the IRS hasn’t been able to collect taxes on the funds. These required minimum distributions (RMDs) allow the IRS to begin to collect those taxes.4

The amount you’ll have to withdraw is based on your age and the amount in your retirement account. If you don’t take— and pay taxes on — your RMDs, you risk a penalty of 50% of the amount you should have taken but didn’t. So if you were required to take $10,000 but only took $4,000, you could pay an additional $3,000 in penalties (50% of the $6,000 you failed to take).

401(k) loan

One way to take money from your 401(k) without paying the 10% penalty — or even paying taxes — may be a 401(k) loan if allowed by your plan. You’ll pay interest on your loan to your account and generally must repay the full amount within five years using substantially level payments.

Keep in mind that if you leave your job or are fired during the loan repayment, you may be required to repay the full amount at once or risk having it considered an early distribution on which you’d have to pay income taxes and the 10% penalty.  Also remember that money withdrawn from your 401(k), even temporarily, gives you less to invest so you may miss out on potential investment growth.

401(k) rollovers

When you leave a job, you generally have four primary options for your vested balance:

  • Leave it in your former employer’s 401(k) plan
  • Roll it into your new employer’s 401(k) plan
  • Roll it into an IRA
  • Withdraw it

Read more: What happens to your 401(k) if you quit your job?

Potentially gain more investing options

Rolling your balance over has several advantages. Not only does it allow you to keep all of your retirement savings in one or two places, but it also may give you a wider variety of investing options.

First, each employer offers its own menu of 401(k) investment options. Some employers have a rather limited menu, and you might find you open up your options by moving the money to your new 401(k) plan.

And you’ll have even more options if you roll your 401(k) into an IRA. When you invest in an IRA, you aren’t limited by an employer’s menu of investment options. Instead, you can invest in anything offered by the financial institution where you keep your IRA.

Read more: Beginner’s guide to portfolio diversification

Roll over your 401k into a new 401(k) or IRA

If you choose to roll your 401(k) into a new 401(k) or an IRA, you’ll have two different options.

First, you can use a direct rollover, where your current plan balance is transferred directly to your new plan. This process is the simplest and has the least amount of tax complications.

The other option is an indirect rollover. In this case, your current plan will send you a check payable to you for your vested 401(k) balance. It’s your responsibility to deposit the check into your new 401(k) or an IRA. You only have 60 days to make the deposit or it will be considered an early withdrawal. 

Note: If your account is paid directly to you, the plan will be required to withhold 20% in federal taxes and possibly state taxes as well.  In that case, you will need to make up the withheld amount from your own money in order to roll your entire account to your new 401(k) or IRA.  Any amount you don’t roll over within 60 days, will be subject to taxes and penalties, if applicable. 

Consider all your options and their features and fees before moving money between accounts.

Types of 401(k)s and retirement accounts

There are many different types of 401(k)s, workplace retirement plans, and even individual retirement plans. Here’s a quick summary of some of the most popular options:

  • Traditional or Roth IRA: A traditional or Roth IRA is similar to a 401(k) in many ways, including when it comes to their tax advantage. However, workers open IRAs on their own directly with a financial institution rather than through a workplace plan.
  • SEP IRA: A Simplified Employee Pension (SEP) IRA is a retirement plan for self-employed individuals with or without employees. Business owners can contribute to their own retirement plan, but then must do the same for their employees.
  • SIMPLE IRA: A Savings Incentive Match Plan for Employees (SIMPLE) IRA is another way for business owners to save for retirement for themselves and their employees with certain required contributions.
  • 457(b) plan: A 457(b) plan is a workplace retirement plan offered by state and local governments, as well as tax-exempt organizations. In most ways, they operate similarly to 401(k) plans, including the option for Roth contributions.
  • 403(b) plan: A 403(b) plan is a retirement plan for public schools, churches, and certain tax-exempt organizations. In most ways, they operate similarly to 401(k) plans, including the option for Roth contributions.

There are also two different types of contributions that can be made to 401(k) plans. While they are similar in most ways, there are some important differences when it comes to their tax advantages.

Traditional pre-tax 401(k) contributions

Traditional pre-tax 401(k) contributions have their tax benefits on the front end. Workers make their contributions tax-free, meaning they reduce taxable income — and, therefore, tax liability — in the current year. The money will potentially grow tax-free in the account but will be subject to income taxes when it's withdrawn from the account.

Who is it good for?

Because of the tax advantage at the time of the contribution, traditional pre-tax 401(k) contributions may be ideal for higher earners who want to reduce their current tax burden. These workers might be on a lower income during retirement, meaning the tax advantage at that time will be less important.

Roth 401(k) contributions

Roth 401(k) contributions have their tax benefits on the back end. Workers make their contributions with after-tax dollars, meaning they don’t reduce their taxable income in the current year. However, the money potentially grows tax-free in the account and won’t be subject to income taxes when it’s withdrawn from the account assuming certain conditions are met.

Read More: Roth 401(k) vs. Roth IRA: Key differences

Who is it good for?

Roth 401(k) contributions might be a good fit for workers who are at the start of their career or expect their earnings to rise significantly in the future. Because they are in a lower tax bracket today, the tax benefit of  pre-tax 401(k) contributions may not be as important. But because their income is expected to rise throughout their life, they may appreciate the tax benefit more during retirement.

401(k) FAQs

Do I have to enroll?

You aren’t required to enroll in your company’s 401(k) plan. Some companies have automatic enrollment, where employees are automatically signed up when they join the company, but you have the choice to opt-out.

Should I invest in a 401(k) even if I have an IRA?

You can invest in both a 401(k) and an IRA, and each has some advantages over the other. Even if you already have an IRA, you might enjoy the employer match in your 401(k), as well as the significantly higher contribution limits.

How much should I contribute to my 401(k)?

Experts recommend contributing at least 10% of your income to retirement accounts. You may contribute some to your 401(k) and some to an IRA, but you should contribute at least enough to your workplace retirement plan to receive your full employer match.  Also, remember that if you have a 401(k) or other retirement plan at work, or if your spouse does, then your contribution to a traditional IRA may not be tax deductible.

Should I max out my 401(k)?

If you can afford to max out your 401(k) by contributing up to the IRS contribution limit, then it’s usually a great idea to do so. You’ll give yourself a head start at saving for retirement. However, you may still reach your retirement goals without maxing out your account.

What happens to my 401(k) account when I leave my job?

When you leave your job, you can choose to keep your 401(k) balance with your former employer if the plan allows you to, roll it into another retirement plan, or withdraw it entirely.

What is a 401(k) recordkeeper?

A 401(k) recordkeeper does the bookkeeping for the company’s retirement plan. The recordkeeper tracks who is invested in the plan, money into the plan, and money out of the plan.

Our take on 401(k) and retirement

More than half of private-sector workers in the United States have access to a 401(k) plan through their employers. These plans offer a variety of benefits, including tax savings, high contribution limits, and potential employer contributions.

If your employer offers a 401(k) and you haven’t signed up yet, consider taking advantage of this tax-advantaged savings tool.

1 IRS, “401(k) Plan Overview,” November 2022.

2 U.S. Bureau of Labor Statistics, “68 percent of private industry workers had access to retirement plans in 2021,” November 2021.

3 Vanguard, “How America Saves 2022,” 2022.

4 IRS, “Retirement Topics — Required Minimum Distributions (RMDs),” April 2023.

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