1. Financial Learning Center
  2. Personal Finances
  3. What Is A 401(k) Retirement Plan?
Woman doing finances at home.

What Is A 401(k) Retirement Plan?

8-minute read

So you’ve started planning and saving for retirement – or you’re at least thinking about it – which means you’re on the right track to securing your financial future and ensuring you’ll be able to make your money last once you retire. Most of us think of this in terms of how we’ll be able to continue our current lifestyle, or better yet improve it, once we leave the workforce. This line of thinking is important, as it’s critical in order to manage your financial obligations even when the paychecks stop. But what if the burden of meeting those financial obligations needs to be eased before you retire? Is there any way to use the money you’re saving toward retirement to help your personal budget now if you don’t have an emergency fund for unexpected expenses? Rest assured, there are plenty of ways to do just that, and one of them is through having a 401(k)retirement plan.

A 401(k), Defined

So what is a 401(k)? Named after the section of the tax code that refers to it, a 401(k) is a retirement plan that your employer sponsors for you, allowing savings to occur on a tax-deferred basis. This means they allow employees of the company to save for retirement without paying taxes on it until it’s withdrawn. Some companies will also match what you put into your 401(k) to a certain amount. Companies will usually hire an administrator to manage the accounts and provide you updates about how they’re doing, but the final decision regarding where you want to invest your money lies with you. There are many different types of 401(k) plans – which we’ll get into later – but they all share some basic characteristics.

How A 401(k) Works

Your employer is responsible for running a 401(k) plan in a way that follows all the various rules and regulations outlined in the tax code, so you don’t have to worry about how all of that works. You do, however, need to familiarize yourself with what type of 401(k) plans your employer offers and how they handle enrollment and ongoing participation – concepts often referred to as “common requirements.” For example, some employers automatically enroll you in the plan when you’re hired, while others require that you log a specified amount of time with the company before being eligible. From a high-level perspective, the key decisions you make are how much you want to invest – keeping in mind how much your employer is willing to match – and what types of funds you want to invest in. That’s the basic definition of how a 401(k) works, but there are numerous options and terms within this broader overview to consider.

Here are a few of them that are important to keep in mind:

  • Defined-Contribution Plan: 401(k) retirement plans are defined-contribution plans. This means that the contributions made to the plan, combined with how the investments perform, determine the balance. This is in contrast to a defined benefit pension plan, which provides a specified amount once you retire.
  • Contribution Limit: The amount you can contribute to your 401(k) is regulated by the tax code and the limit changes from year to year. Recently, the IRS announced that employees in 401(k)plans will be able to contribute up to $19,500 this year. 
  • Catch-Up Contributions: One exception to the contribution limit is a type of 401(k) option people age 50 or older can make called a catch-up contribution. This allows these individuals to add funds to their account as they get closer to retirement to ensure they have enough money to live on when they stop working.
  • 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.
  • Rollover: When you transfer funds from one retirement plan to another, it’s called a rollover. One example of this would be moving funds from your 401(k) to an individual retirement account. 
  • Withdrawals: Taking money out of your 401(k) is governed by a number of different rules and regulations. For example, if you take money out before you turn 59 ½ years old, you may be charged a 10% penalty by the IRS. In addition, you’ll pay an extra percentage when you file your taxes, as the funds you received will be considered pretax income.

Types Of 401(k) Plans

Now that you have a basic understanding of what 401(k) plans are and how they work, let’s dive into the different types of plans and what differentiates them.

  • Traditional 401(k): This is 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): This 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 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. 
  • Tiered Profit Sharing 401(k): This plan allows the company to roll profits into the account and also 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.
  • Simple401(k) plan: Under this plan, employer and employee contributions are fully vested and there are rules about employer contributions. The company must make a matching contribution of up to 3% or a nonelective contribution of 2% of each eligible employee’s pay.

Why Is Having A 401(k) Important?

So why does any of this matter to you? Understanding the definition of 401(k) plans and how they work doesn’t mean a lot unless it comes along with an understanding of why they are important to you. Knowing when to save and when to invest are issues most Americans struggle with, and your 401(k) can help with this. The fund will not only provide you with greater savings toward your retirement, but those savings will also grow faster as investments due to the fact that they won’t be subject to income tax until you begin to make withdrawals. With your money growing faster and your employer likely chipping in on top of that, the importance of having a 401(k) retirement plan comes into clear focus.

The Perks Of Having A 401(k)

By now you’ve likely come to the conclusion that having a 401(k) retirement plan is important – but there’s more! In addition to the reasons we’ve already outlined, there are a few more specific perks that accompany a 401(k).

  • Tax Benefits: You already know that contributions to your 401(k) are tax deferred, meaning you don't pay taxes on them until you withdraw, allowing 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. Not all retirement plans allow for this, making a clear case for the importance of having a 401(k).
  • Employer Match: In most cases, you aren’t the only one contributing to your 401(k) – your employer does, 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.
  • Security of Funds: Typically you can’t access the funds in your 401(k) until you are nearing retirement age without a big tax penalty. This incentivizes you to let your money grow in the fund until you retire and not use it until you really need it.
  • Added Retirement Stability: Planning for retirement is something most of us worry about. How much do I need to save? Will there be enough to sustain my current lifestyle? How can I protect my assets? Having a 401(k)can alleviate these concerns considerably by creating a place for funds dedicated to easing the financial stress associated with retirement.

Other Common Types Of Retirement Plans

Understanding the true value of having a 401(k) requires some context. Let’s take a look at how they compare to other common types of retirement plans.

  • Traditional IRAs: A traditional individual retirement account offers many similar benefits to a 401(k). For example, these accounts allow for you to invest money that can be deducted on your tax return, and the investment earnings on those contributions are not taxed until they are withdrawn. However, the distinction between a traditional IRA and a 401(k) is that an IRA is not employer-sponsored, so it does not have the added benefit of employer contributions that often accompany a 401(k). In addition, a traditional IRA does not allow your money to grow tax-free.
  • Roth IRAs: This type of retirement account is similar to a traditional IRA but with two key differences: one, the contributions you make to a Roth IRA are not able to be deducted from your taxes the year they are made; two, the contributions you make are able to grow tax-free. There are also a few key differences between a Roth IRA and a 401(k). First off, your money can be withdrawn from your Roth IRA whenever you want without a tax penalty. This is a benefit over a 401(k), where you have to be 59½ years old to withdraw funds penalty-free. There is also a distinction regarding when you pay the taxes for each type of account. With a 401(k), you make contributions before taxes, giving you an immediate tax break. With a Roth IRA, you make contributions after taxes, which means your investments will grow tax-free.
  • 403(b)s: This type of plan, referred to as a 403(b) or a tax-sheltered annuity plan, is essentially identical to a 401(k), but only certain types of employers can offer it. Only tax-exempt organizations like schools or churches can make 403(b)s available to their employees.
  • Defined Benefit Plans: Often referred to as a pension, 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 payout when you retire and a 401(k) is not.

So when you think about retirement, it’s a good idea to strongly consider a 401(k). It allows you and your employer to contribute money to your retirement, watch it grow while you’re working, and allow it to fund your life once you decide to leave the workforce and enjoy those golden years.

Apply For A Mortgage Online

NMLS #3030