What is a 401(k)?
August 9, 2022 6 min read
When it comes to saving for retirement, being prepared is key. If you’re working for a company that offers a 401(k) retirement plan, it can be a great option to help you save for your future.
Maybe it’s your first time setting up a 401(k), or maybe you’re still a bit hazy on the details. Either way, you aren’t alone. Here’s the rundown on 401(k)s and how they can help you plan for your future.
- 401(k)s are employer-sponsored investment accounts that help you save for retirement.
- There are different types of 401(k) plans. The most common are the traditional 401(k) and the Roth 401(k).
- Employers can match your 401(k) contributions and help you save even more for retirement.
- 401(k) plans have tax benefits and are considered part of a person's net worth.
What is a 401(k) & how does a 401(k) work?
A 401(k) is an investment account offered by employers to provide an incentive for their employees to save for retirement.
A 401(k) allows an employee to choose a set amount—or percentage—they would like taken out of their paycheck. The employer then automatically deducts this contribution amount and invests it in financial products—like mutual funds, stocks and bonds—chosen by the employee.
The idea behind a 401(k) is that your investments will grow over time thanks to the power of compound interest. Then, when you’re ready to retire, you’ll have access to the money in the account.
Understanding 401(k) employer contributions
One of the benefits of a 401(k) is that your employer can also choose to contribute to your 401(k)—and many employers do just that. You might hear this type of contribution called an “employer match” or “matching contributions.”
Employer contributions vary, and each company can choose how much of a match they want to offer. A company might, for example, contribute a 50% match up to 6% of an employee’s salary. That means that if an employee chooses to invest 6% of their salary in their 401(k), their employer would contribute an additional amount equal to 3% of the employee’s salary.
401(k) contribution limits
The Internal Revenue Service (IRS) sets a contribution limit for the amount that you can invest in your 401(k) each year. This limit applies only to employees—employer contributions don’t count toward the limit.
Keep in mind that the IRS frequently changes the contribution limit annually to account for factors like inflation. For example, the limit was increased from $19,500 in 2021 to $20,500 in 2022.
It’s also worth noting that those age 50 and older may be able to make an additional contribution—called a “catch-up contribution”—to their 401(k). The current limit is $6,500, which adds up to a total contribution limit of $27,000.
401(k) tax benefits
In addition to compound interest and employer contributions, tax-related incentives are a benefit of 401(k)s. How exactly these tax benefits work depends on the type of 401(k)—whether it’s a traditional 401(k) or a Roth 401(k).
Traditional 401(k) vs. Roth 401(k): What’s the difference?
The basic difference between a traditional 401(k) and a Roth 401(k) is when exactly they’re taxed.
With a traditional 401(k), your contributions are made with pre-tax dollars. Then, your contributions and earnings grow tax-deferred—you don’t pay taxes on the money in your 401(k) until you withdraw it from the account. When you withdraw the money in retirement, the IRS considers it to be income and it’s taxed at your current tax rate.
With a Roth 401(k), on the other hand, your contributions are made with after-tax dollars. Then, when you withdraw the money in retirement, your withdrawals—of both your contributions and earnings—are generally tax-free.
Is a Roth 401(k) better than a traditional 401(k)?
Whether you choose a traditional 401(k) or a Roth 401(k), the tax implications might be better or worse for you depending on a variety of factors—like your age, your current income and what your income will be when you retire.
So, if you aren’t sure which one is a better option for you, consider meeting with a trusted financial expert for guidance.
Early withdrawals from a 401(k)
You can typically start making penalty-free withdrawals from your 401(k) at the age of 59½.
But life doesn’t always go as planned. Money management can be hard, and unexpected financial challenges can pop up at any time. So, while saving for retirement is important, people don’t always have enough in their savings account to cover an unexpected expense.
So if you need to take an early withdrawal from your 401(k), here are some things you’ll want to be aware of:
- 401(k)s have an early withdrawal tax penalty of 10%.
- There are qualifying life events—like certain medical expenses—that are exempt from a tax penalty.
Instead of an early withdrawal, another option could be to take out a loan against your 401(k). When it comes to borrowing from a 401(k), here are a few things to keep in mind:
- The loan needs to be applied for through and approved by the employer or plan administrator.
- Loan amounts are limited to 50% of the 401(k) balance or a maximum of $50,000 if the account is fully vested—whichever is lower.
- As the IRS explains, “Generally, the employee must repay a plan loan within five years and must make payments at least quarterly.” But there are some exceptions—like using a 401(k) loan to buy a home.
- If an employee borrows from their 401(k) and then leaves the company, the employer may require the outstanding balance in full. In this case, a borrower has until the due date of their tax return to pay it back.
How to start a 401(k)
If your employer offers a 401(k) plan, you can usually set it up by contacting your human resources department. You’ll likely decide what amount or percentage of your pay you want to set aside each pay period, choose the types of investments you want to invest in and fill out paperwork that allows your employer to make automatic deductions.
If your 401(k) is managed, you may go through this process directly with your company’s financial adviser or bank.
401(k) plans in a nutshell
A 401(k) plan can be a great retirement planning tool because of its financial and tax benefits. Having a 401(k) can give you more options in retirement—even if life throws you a curveball.
Interested in learning about 401(k) alternatives? Check out different types of retirement plans to consider.