What Is a 401(k) and How Does It Work?

What Is a 401(k) Plan?

A 401(k) plan is a retirement savings plan offered by many American employers that has tax advantages for the saver. It is named after a section of the U.S. Internal Revenue Code (IRC).

The employee who signs up for a 401(k) agrees to have a percentage of each paycheck paid directly into an investment account. The employer may match part or all of that contribution. The employee gets to choose among a number of investment options, usually mutual funds.

How 401(k) Plans Work

The 401(k) plan was designed by the United States Congress to encourage Americans to save for retirement. Among the benefits they offer is tax savings.

There are two main options, each with distinct tax advantages.

Traditional 401(k)

With a traditional 401(k), employee contributions are deducted from gross income, meaning the money comes from the employee's payroll before income taxes have been deducted. As a result, the employee's taxable income is reduced by the total amount of contributions for the year and can be reported as a tax deduction for that tax year. No taxes are due on the money contributed or the investment earnings until the employee withdraws the money, usually in retirement.

Roth 401(k)

With a Roth 401(k), contributions are deducted from the employee's after-tax income, meaning contributions come from the employee's pay after income taxes have been deducted. As a result, there is no tax deduction in the year of the contribution. When the money is withdrawn during retirement, no additional taxes are due on the employee's contribution or the investment earnings.

However, not all employers offer the option of a Roth account. If the Roth is offered, the employee can pick one or the other or a mix of both, up to annual limits on their tax-deductible contributions.

Contributing to a 401(k) Plan

A 401(k) is a defined contribution plan. The employee and employer can make contributions to the account up to the dollar limits set by the Internal Revenue Service (IRS).

A defined contribution plan is an alternative to the traditional pension, known in IRS lingo as a defined-benefit plan. With a pension, the employer is committed to providing a specific amount of money to the employee for life during retirement.

In recent decades, 401(k) plans have become more common, and traditional pensions have become rare as employers shifted the responsibility and risk of saving for retirement to their employees.

Employees also are responsible for choosing the specific investments within their 401(k) accounts from a selection their employer offers. Those offerings typically include an assortment of stock and bond mutual funds and target-date funds designed to reduce the risk of investment losses as the employee approaches retirement.

They may also include guaranteed investment contracts (GICs) issued by insurance companies and sometimes the employer's own stock.

Contribution Limits

The maximum amount that an employee or employer can contribute to a 401(k) plan is adjusted periodically to account for inflation, which is a metric that measures rising prices in an economy.

For 2022, the annual limit on employee contributions is $20,500 per year for workers under age 50. However, those aged 50 and over can make a $6,500 catch-up contribution in 2022.

If the employer also contributes or if the employee elects to make additional, non-deductible after-tax contributions to their traditional 401(k) account, there is a total employee-and-employer contribution amount for the year.

2022

• For workers under 50 years old, the total employee-employer contributions cannot exceed $61,000 per year.
• If the catch-up contribution for those 50 and over is included, the limit is $67,500.

Employer Matching

Employers who match their employee contributions use various formulas to calculate that match.

For instance, an employer might match 50 cents for every dollar the employee contributes up to a certain percentage of salary.

Financial advisors often recommend that employees contribute at least enough money to their 401(k) plans to get the full employer match.

Contributing to Both a Traditional and a Roth 401(k)

If their employer offers both types of 401(k) plans, employees can split their contributions, putting some money into a traditional 401(k) and some into a Roth 401(k).

However, their total contribution to the two types of accounts can't exceed the limit for one account (such as $20,500 for those under age 50 in 2022).

How Does a 401(k) Earn Money?

Your contributions to your 401(k) account are invested according to the choices you make from the selection your employer offers. As noted above, these options typically include an assortment of stock and bond mutual funds and target-date funds designed to reduce the risk of investment losses as you get closer to retirement.

How much money you contribute each year, whether or not your company matches your contribution, how your contributions are invested and the annual rate of return on those investments, and the number of years you have until retirement all contribute to how quickly and how much your money will grow. And provided you don't remove funds from your account, you don't have to pay taxes on investment gains, interest, or dividends until you withdraw money from the account after retirement (unless you have a Roth 401(k), in which case you don't have to pay taxes on qualified withdrawals when you retire).

What's more, if you open a 401(k) when you are young, it has the potential to earn more money for you, thanks to the power of compounding. The benefit of compounding is that returns generated by savings can be reinvested back into the account and begin generating returns of their own. Over a period of many years, the compounded earnings on your 401(k) account can actually be larger than the contributions you have made to the account. In this way, as you keep contributing to your 401(k), it has the potential to grow into a sizable chunk of money over time.

Taking Withdrawals From a 401(k)

Once money goes into a 401(k), it is difficult to withdraw it without paying taxes on the withdrawal amounts.

"Make sure that you still save enough on the outside for emergencies and expenses you may have before retirement," says Dan Stewart, CFA®, president of Revere Asset Management Inc., in Dallas. "Do not put all of your savings into your 401(k) where you cannot easily access it, if necessary."

The earnings in a 401(k) account are tax-deferred in the case of traditional 401(k)s and tax-free in the case of Roths. When the traditional 401(k) owner makes withdrawals, that money (which has never been taxed) will be taxed as ordinary income. Roth account owners have already paid income tax on the money they contributed to the plan and will owe no tax on their withdrawals as long as they satisfy certain requirements.

Both traditional and Roth 401(k) owners must be at least age 59½—or meet other criteria spelled out by the IRS, such as being totally and permanently disabled—when they start to make withdrawals.

Otherwise, they usually will face an additional 10% early distribution penalty tax on top of any other tax they owe.

Some employers allow employees to take out a loan against their contributions to a 401(k) plan. The employee is essentially borrowing from themselves. If you take out a 401(k) loan, please consider that if you leave the job before the loan is repaid, you'll have to repay it in a lump sum or face the 10% penalty for an early withdrawal.

Required Minimum Distributions (RMDs)

Traditional 401(k) account holders are subject to required minimum distributions (RMDs) after reaching a certain age. (Withdrawals are often referred to as distributions in IRS parlance.)

After age 72, account owners who have retired must withdraw at least a specified percentage from their 401(k) plans using IRS tables based on their life expectancy at the time. (Prior to 2020, the RMD age was 70½ years old.)

Note that distributions from a traditional 401(k) are taxable. Qualified withdrawals from a Roth 401(k) are not.

Traditional 401(k) vs. Roth 401(k)

When 401(k) plans became available in 1978, companies and their employees had just one choice: the traditional 401(k). Then in 2006, Roth 401(k)s arrived. Roths are named for former U.S. Senator William Roth of Delaware, the primary sponsor of the 1997 legislation that made the Roth IRA possible.

While Roth 401(k)s were a little slow to catch on, many employers now offer them. So the first decision employees often have to make is between a Roth and a traditional (40l(k).

As a general rule, employees who expect to be in a lower marginal tax bracket after they retire might want to opt for a traditional 401(k) and take advantage of the immediate tax break.

On the other hand, employees who expect to be in a higher bracket after retiring might opt for the Roth so that they can avoid taxes on their savings later. Also important—especially if the Roth has years to grow—is that there is no tax on withdrawals, which means that all the money the contributions earn over decades of being in the account is tax-free.

As a practical matter, the Roth reduces your immediate spending power more than a traditional 401(k) plan. That matters if your budget is tight.

Since no one can predict what tax rates will be decades from now, neither type of 401(k) is a sure thing. For that reason, many financial advisors suggest that people hedge their bets, putting some of their money into each.

When You Leave Your Job

When you leave a company where you've been employed and you have a 401(k) plan, you generally have four options:

1. Withdraw the Money

Withdrawing the money is usually a bad idea unless you urgently need the cash. The money will be taxable in the year it's withdrawn. You will be hit with the additional 10% early distribution tax unless you are over 59½, permanently disabled, or meet the other IRS criteria for an exception to the rule.

This rule was suspended for 2020 for those affected by the 2020 COVID-19 economic crisis.

In the case of Roth IRAs, you can withdraw your contributions (but not any profits) tax-free and without penalty at any time as long as you have had the account for at least five years. Remember, however, that you're still diminishing your retirement savings, which you may regret later.

2. Roll Your 401(k) into an IRA

By moving the money into an IRA at a brokerage firm, a mutual fund company, or a bank, you can avoid immediate taxes and maintain the account's tax-advantaged status. What's more, you will be able to select among a wider range of investment choices than with your employer's plan.

The IRS has relatively strict rules on rollovers and how they need to be accomplished, and running afoul of them is costly. Typically, the financial institution that is in line to receive the money will be more than happy to help with the process and avoid any missteps.

3. Leave Your 401(k) With the Old Employer

In many cases, employers will permit a departing employee to keep a 401(k) account in their old plan indefinitely, though the employee can't make any further contributions to it. This generally applies to accounts worth at least $5,000. In the case of smaller accounts, the employer may give the employee no choice but to move the money elsewhere.

Leaving 401(k) money where it is can make sense if the old employer's plan is well managed and you are satisfied with the investment choices it offers. The danger is that employees who change jobs over the course of their careers can leave a trail of old 401(k) plans and may forget about one or more of them. Their heirs might also be unaware of the existence of the accounts.

4. Move Your 401(k) to a New Employer

You can usually move your 401(k) balance to your new employer's plan. As with an IRA rollover, this maintains the account's tax-deferred status and avoids immediate taxes.

It could be a wise move if you aren't comfortable with making the investment decisions involved in managing a rollover IRA and would rather leave some of that work to the new plan's administrator.