401(k): What It Is And How It Works
Andrew Dehan8-minute read
February 21, 2022
Whether you’ve started planning and saving for retirement or are just thinking about it, knowing the terminology will help you make the most of your savings. We want you to be 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 improve it once we leave the workforce. This line of thinking is important, as it’s critical to manage your financial obligations even when the paychecks stop.
Along with having an emergency fund, it’s important to have money saved away for a date when you can retire. One of the ways to save is through a 401(k) retirement plan.
What Is A 401(k)?
Named after the section of the tax code, a 401(k) is a retirement plan that your employer sponsors for you.
There are many types of 401(k)s. Some allow you to defer tax payment on the investment until you withdraw. Others let you pay the tax on the money upfront. Each have their advantages.
The defining characteristic of all 401(k)s is that they’re company-sponsored retirement plans. As opposed to you investing on your own, your employer sets up a plan to encourage you to save. Employers may also match a certain percentage of contributions as a benefit to increase employee loyalty.
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.
Let’s go into more detail on how these plans work.
How Does A 401(k) Work?
Your employer is responsible for running a 401(k) plan in a way that follows the regulations outlined in the tax code. You don’t need to worry about how the regulations work, but you do need to familiarize yourself with what type of 401(k) plans your employer offers and how they handle enrollment and ongoing participation. These concepts are often referred to as “common requirements.”
For example, some employers automatically enroll you in the plan when you’re hired, while others require you log a specified amount of time with the company before you’re eligible. From a high-level perspective, the key decisions you make are how much you want to invest and what types of funds you want to invest in. If your employer matches contributions up to a certain amount, keep that in mind.
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:
- 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 contrasts with 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. For 2021, the maximum you can contribute to your 401(k) is $19,500 if you’re younger than 50. If you’re older, or will be turning 50 in 2021, you can save an additional $6,500.
- 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 several different rules and regulations. For example, 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 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 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.
- SIMPLE 401(k) Plan: This is the Savings Incentive Match Plan for Employees. 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.
- 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 a Roth 401(k) has over a Traditional 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, which they do not in a Traditional 401(k). This extra yearly taxable income could bump you into a higher tax bracket.
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 concluded 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. 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. 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 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. 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. 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.
- 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 pay out when you retire and a 401(k) is not.
- Self-employed plans: If you’re self-employed, a Simplified Employee Pension (SEP) lets you contribute 25% of your net earnings up to $58,000 in 2021. 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.
Cashing Out A 401(k)
Cashing out your 401(k) looks different depending on a lot of factors. If you’re over the age of 59½ you can withdraw from your 401(k) without having to pay an early withdrawal fee. Depending on the type of plan you have, and if you’re still working, there may be different rules about how much you can cash out at a time.
If you’re between the ages of 55 and 59½ and no longer work for the employer that the 401(k) is with, you can withdraw without facing early withdrawal fees. This is what some people refer to as the “Rule of 55.”
If you’re younger than 55, you normally will face an extra fee of 10% for withdrawals. Due to COVID-19, Congress has waived this fee to people living in areas highly affected by the virus. Right now, that’s all 50 states. Withdrawing early from your 401(k) should be a last resort.
Any money you pull out of the stock market can be a loss if the market grows. It may make more financial sense to take out a loan to pay your bills if it’s available to you.
The Bottom Line
Saving for your retirement is incredibly important. The earlier you start, the better. Research what plans your employer offers, if any, and consider your options when it comes to investing. By learning how investing works, you can start building your nest egg and planning to retire. If you do it right, maybe you’ll end up somewhere nice where you can live out your sunset years.
Want to learn more about saving and investing? Check out more personal finance content on Rocket HQSM.
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