What Is A 401(k) And How Does It Work?

When it comes to saving for retirement, many experts consider your 401(k) the right place to stash your nest egg. But if you aren’t sure what a 401(k) is, it’s helpful to get clear on the details before you dive into saving in this type of retirement account.

4 Benefits Of 401(k) Plans

Investing in a 401(k) plan comes with some key benefits, including the following.

1. Employer matching: Many employers offer to match your 401(k) contributions up to a particular percentage. Essentially, this match doubles your 401(k) contributions right off the bat, up to your employer’s limit. Skipping your employer match is like leaving free money on the table.

2. Potential income tax benefits: A 401(k) is a tax-advantaged account, which means the funds you put into your 401(k) are considered pretax. This advantage allows you to lower your taxable income for the year through 401(k) contributions.

3. Automatic contributions: Most employers allow you to make your 401(k) contributions automatically from your paycheck. Since the money never touches your checking account, it’s often easier to stick to the plan of saving those funds for the future.

4. Nest egg for retirement tucked away safely: Typically, you cannot access the funds in your 401(k) before retirement age without facing a big penalty. This means you’ll be motivated to leave those funds untouched until your golden years.

What Is A 401(k) Retirement Savings Plan?

A 401(k) is a profit-sharing retirement savings plan that allows employees to contribute some of their pretax dollars directly into a retirement account. In many cases, employers match a percentage of an employee’s contributions to help the employee’s account grow faster.

Notably, a 401(k) is a type of defined contribution plan. That means the funds you invest are defined, but the funds you can withdraw in retirement are based on the returns your assets achieve within the retirement account. In contrast to a defined-benefit plan, like a pension, the funds you withdraw from your 401(k) vary based on the money you put in and the assets you choose to invest in.

The Benefits Of Having A 401(k)

As a saver with an eye on your future retirement, there are many benefits of having a 401(k). Below is a closer look at some of those perks.

Tax Benefits

The contributions that you make to your 401(k) are tax deferred, meaning you don't pay taxes on them until you withdraw. This allows them to grow faster.

The other key tax benefit is that you make contributions to your 401(k) before you pay taxes each year, which allows you to deduct those contributions that same year. This lowers your taxable income for the year, saving you even more money. Depending on your situation, that could push your income into a lower Internal Revenue Service (IRS) tax bracket. Since not all retirement plans allow for the deduction, the tax benefits of a 401(k) are especially highlighted.

Employer Matching

In most cases, you aren’t the only one contributing to your 401(k) – your employer is, too. Matching has limits that vary by employer but having a retirement plan where the company you work for kicks in some money is certainly an advantage.

Whenever possible, contribute enough money into your 401(k) to max out your employer’s matching contributions. The match essentially means you double your funds for retirement immediately.

Low-Stress Retirement Saving

A 401(k) can make it easier to save for retirement because of the ability to automate your savings. When you set up an automatic contribution, you’ll be saving for retirement with every paycheck.

How A 401(k) Plan Works

Your employer is responsible for running a 401(k) plan in a way that follows the regulations outlined in the tax code. While you don’t need to worry about how the regulations work, you do need to familiarize yourself with the details of your employer’s 401(k) plan.

We will outline some of the details to consider below. But don’t hesitate to get in contact with your Human Resources department to find out more about the inner workings of your company’s 401(k).

Who’s Eligible For A 401(k) Retirement Plan?

If you are at least 21 years old and have banked at least 1 year of service with your employer, then your employer must include you in their retirement offerings. If your employer doesn’t offer a 401(k), then you aren’t able to get one on your own.

Notably, your company can choose to let you participate in its 401(k) plan as soon as you start. But you’ll need to ask your HR department if you are immediately eligible or if you have to wait to enroll in the company’s 401(k) program.

How Do You Enroll?

If you want to enroll in your workplace 401(k), you’ll need to fill out some forms. Depending on the company, you might do this online, via an app, or with pen and paper. In any case, your HR department should be able to provide the steps you’ll need to take to set up your 401(k).

How Do Workers Contribute To A 401(k)?

The funds you contribute to your 401(k) come directly out of your paycheck. In most cases, you decide how much to contribute as a percentage of your income. For example, you might decide to contribute 5% of each paycheck to your 401(k).

You can set up this automatic contribution either online through the 401(k) platform’s website or directly with your HR department.

What Is Vesting?

When it comes to 401(k) retirement plans, vesting is essentially a fancy word for ownership. Each year you own a certain percentage of your account that your employer cannot forfeit or take from you.

Immediate vesting means that there is no waiting period for full ownership. But 3-year vesting means you’ll have to wait three years to completely own the funds in your 401(k). Notably, this applies to the matching contributions provided by the company. You’ll always own 100% of your own contributions.

Does A 401(k) Have Annual Contribution Limits?

The amount you can contribute to your 401(k) is regulated by the tax code and the limit changes from year to year. For 2024, the maximum you can contribute to your 401(k) is $23,000 if you’re younger than 50.

If you’re older, or will be turning 50 in 2024, you can make catch-up contributions of up to $7,500.

How Do Withdrawals Work?

Taking money out of your 401(k) is governed by several different rules and regulations. In general, you’ll be expected to wait until age 59.5 to make withdrawals. At that point, you’ll pay regular income tax on the funds.

If you take money out before you turn 59½ years old, you may be charged a 10% penalty by the IRS. In addition, if it’s a Traditional 401(k), you’ll pay extra when you file your taxes, as the funds you receive will be considered pretax income.

The IRS does allow for some hardship withdrawals, which means you can take out the money early without a penalty. Some examples of qualifying hardships include a birth, natural disaster, or as a down payment of up to $10,000 for first-time homebuyers.

What If You Get A New Job?

If you leave your job, you get to keep your 401(k) funds. But you’ll have several choices about what you can do with those funds. For example, you might be able to leave the funds in the account with your old employer until you decide to make a change. You could roll it over to a new 401(k) or an individual retirement account, or you could take a cash distribution if you are comfortable with the taxes and penalties. Consult a financial professional to discuss your options.

How Do You Handle Rollovers Into Other Accounts?

When you transfer funds from one retirement plan to another, it’s called a rollover. One example of this would be a 401(k) to Roth IRA rollover, which involves moving your funds from the 401(k) to a Roth IRA.

Types Of 401(k) Plans

Not every 401(k) plan is the same. Below is a closer look at some of the different types of plans.

Traditional 401(k)

A traditional 401(k) is by far the most common option. And it’s the plan we have been discussing so far, with the employee making contributions – along with the employer if they offer matching – to grow the account.

Under this plan, the employer provides some options for the employee to choose from but oversees the management of funds in the account – usually with the help of a fund administrator.

Self-Directed 401(k)

A self-directed 401(k) plan has the same structure for adding funds to the plan as a Traditional 401(k) but varies in terms of how the fund is managed.

With a self-directed plan, the employee manages the funds instead of leaving that task to the employer or designated fund administrator. This gives the employee a wider array of stocks and other investments to choose from, as they are not limited to the choices the employer offers in a traditional plan.

Roth 401(k)

A Roth 401(k) is a type of plan where, unlike a Traditional 401(k), you pay the income tax before you contribute to the 401(k). It’s similar in this way to a Roth IRA.

The advantage of an after-tax contribution into a Roth 401(k) is when it comes time to withdraw, you’ve already paid the taxes on the investment and will not pay taxes on earnings. The disadvantage is savings in Roth 401(k) count as yearly taxable income, while they do not in a Traditional 401(k). This extra yearly taxable income could bump you into a higher tax bracket.

SIMPLE And Solo 401(k)

SIMPLE and solo 401(k)s are designed for self-employed Americans. Under the SIMPLE 401(k), employer and employee contributions are fully vested and there are rules about employer contributions.

Both are options to consider for self-employed individuals seeking a tax-advantaged way to save for retirement.

Tiered Profit Sharing 401(k)

A tiered profit sharing 401(k) allows the company to roll profits into the account and create tiers of employees with different profit allocations. Employees that the company determines are contributing more to the overall success of the business receive more funds.

Alternatives To A 401(k)

When it comes to saving for retirement, a 401(k) isn’t the only option you have. Below are some alternatives to a 401(k).

Individual Retirement Account (IRA)

A traditional individual retirement account (IRA) offers many similar benefits to a 401(k). Notably, you’ll be able to make contributions to this account pretax, which means the money you invest can be deducted on your tax return, and the investment earnings on those contributions are not taxed until they are withdrawn.

The distinction between a Traditional IRA and a 401(k) is that an IRA is not employer-sponsored. With that, you have a bit more control over the account. If you don’t have access to a workplace 401(k) or want to save beyond the limits of a 401(k), adding an IRA is a good option.

Roth IRAs are another popular choice. While similar to a traditional IRA, the Roth option means that the contributions you make to a Roth IRA are not able to be deducted from your taxes the year they are made. Additionally, the contributions you make can grow tax-free. With a Roth IRA, your money can be withdrawn whenever you want without a tax penalty. This is a benefit over a 401(k), where you must be 59½ years old to withdraw funds penalty-free.

Pensions

A pension is a type of defined-benefit plan. A defined-benefit plan is a retirement account that your employer pays for in its entirety and has a defined amount paid out when you retire.

The main distinction between a 401(k) and a pension is that a pension is guaranteed to pay out when you retire and a 401(k) is not.

403(b) Plans

403(b) plans are almost identical to 401(k) plans. The catch is that only certain types of employers can offer a 403(b). Only tax-exempt organizations like schools or churches can make 403(b)s available to their employees.

Self-Employed Pension Plans

If you’re self-employed, a Simplified Employee Pension (SEP) lets you contribute either 25% of your net earnings or up to $69,000 in 2024; the lesser of the two is your limit. You can also set up a one-participant 401(k) plan, which works like a Traditional 401(k), but only for you and a spouse.

FAQs About 401(k) Accounts

You have questions about 401(k) accounts. We have answers.

Should I cash out my 401(k) early?

It’s usually not a good idea to cash out a 401(k) early. The point of a 401(k) is to save for your golden years. Additionally, cashing out your funds early means you’ll face withdrawal penalties.

What happens to my 401(k) if I quit my job?

If you quit your job, you can take your 401(k) with you or leave it with your previous employer. You may also be able to roll it over into your new employer’s plan or cash it out if you can stomach the penalties.

Can my 401(k) lose money?

Yes, it’s entirely possible for your 401(k) to lose money. If the underlying investments in your 401(k) lose value, then your account will lose money.

The Bottom Line: A 401(k) Is A Valuable Retirement Savings Tool

A 401(k) is a useful account to build your retirement nest egg. But it’s important to understand the rules of your employer’s plan before stashing money away.

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