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What Is a 401(k)?

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What we’ll cover:

A 401(k) plan is a type of workplace retirement account that many employers include in their benefits package. If you’re considering a job offer, a 401(k) is an important benefit to look out for because it could help you build a nice nest egg. 

At the most basic level, here’s how it works: Once you’ve signed up for a 401(k), you can tell your employer to take a portion of your paychecks (usually a certain percentage) and put that money into your 401(k) account where it’ll be invested. 

Now, some of you may be wondering: If that’s the case, why not use a more descriptive name for these accounts - like “Super Neat Workplace Retirement Plan” or “Employer-Sponsored Nest Egg?” Where in the world did the term “401(k)” come from? 

Probably the last place you’d suspect – the U.S. tax code! These workplace retirement plans are named after a specific part of the Internal Revenue Code: Section 401(k). 

This fun fact actually brings us to another key feature of these plans: 401(k)s are considered tax-advantaged investment accounts. In other words, putting money away in a 401(k) could offer potential tax benefits. 

Ahead, we’ll take a closer look at how a 401(k) works. We’ll start with the basics and then go over a few key contribution and withdrawal rules to keep in mind.

How does a 401(k) work? Traditional vs. Roth 401(k)

There are actually several different types of 401(k) plans that employers may offer. (Sometimes, you may see your employer or company being referred to as the “plan sponsor.”) To help keep things simple, we’ll focus on two basic ones that you’re likely to come across at work: a traditional 401(k) and Roth 401(k). 

Traditional and Roth plans share many features. Both allow you to contribute a portion of your paychecks and invest that money, letting it potentially grow over time in your 401(k) account. A key difference is how these accounts are taxed. 

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With a traditional 401(k), you contribute pre-tax dollars through automatic payroll deductions. This is when your employer deducts your 401(k) contribution from your paycheck before taxes are calculated and taken out, which can help lower your taxable income. 

Those pre-tax dollars are then put into your 401(k) account where the money can grow tax-deferred. This basically means you don’t have to pay taxes on your contributions and potential earnings until you take the money out (note: you may be subject to an early withdrawal penalty if you take money out before the age of 59 ½). In short, you can get a tax break up front when you contribute to a traditional 401(k). 

A Roth 401(k) essentially operates the opposite way. You contribute to your 401(k) account with after-tax dollars. But generally, withdrawals from your Roth 401(k) are tax-free starting at the age of 59 ½ (so long as you’ve had the account for five years). 

Good to know: Unlike traditional 401(k) plans, which have been around for decades, Roth 401(k)s didn’t come onto the scene until 2006. And some employers may not offer Roth 401(k)s due to certain administrative considerations. 

Traditional vs. Roth 401(k): Is one better than the other?

From a tax perspective, it’s a question of whether you want to pay taxes now (Roth) or later (Traditional). And that may depend, in part, on what you think your retirement future is going to look like. For instance, do you expect to be in a lower or higher tax bracket down the road?

There are many other factors to consider, so it’s a good idea to consult a tax professional or financial advisor if you have any questions about your financial situation. 

401(k) investment options. When you sign up for a 401(k) plan, you can usually choose an investment option for your money. The number and variety of options will depend on your plan sponsor. At the start, your employer may enroll you in a default option like a lifecycle or “target-date” fund, which automatically adjusts your mix of investments as you get closer to your target date (for instance, your retirement year). You can stick with the default option or choose to invest in other types of funds from the plan provider based on your risk tolerance and investment timeline. 

401(k) employer match

We mentioned earlier that employers often include a 401(k) plan in their benefits package. When evaluating 401(k) benefits, one question you’ll want to ask is whether there’s an employer match. (Not all companies offer one.)

Some employers may offer to match your 401(k) contributions up to a certain amount each year. The matching formula will vary from company to company. Some places will match dollar for dollar or 50 cents to the dollar up to a certain annual limit. 

It’s important to get the details ahead of time so that you can try to get the full match each year. (You work hard – don’t leave any money the table!)

401(k)s can be a great tool to help you save for retirement. 

You’ll also want to ask if there’s a “vesting” period. Many employers require you to stay with the company a few years before the employer contributions become fully vested – that is, yours to take with you with when you leave the company. 

Some 401(k) rules to keep in mind

Some 401(k) plan details, such as eligibility requirements, investment options and vesting timeline, will vary from company to company. 

When it comes to the rules for things like contribution limits, withdrawals and required minimum distributions (RMDs), generally, the IRS is the boss. Let’s go over these in turn. 

401(k) contribution limits

Like many other types of retirement plans, 401(k)s come with annual contribution limits, meaning you can only squirrel away a certain amount of money each year. For the 2021 tax year, you can stash up to $19,500 in your 401(k) plan. 

And if you’re age 50 or older (and your plan allows it), you can make “catch-up contributions” to help supercharge your retirement savings. Catch-up contributions allow you to put in an extra $6,500, bringing your annual maximum contribution limit to a total of $26,000 ($19,5000 + $6,500). Nice!

Good to know: 401(k) maximum contribution limits are subject to change each year. Visit the IRS for the most up-to-date information. 

401(k) withdrawal rules

Generally speaking, you can start to withdraw from your 401(k) plan (traditional or Roth) penalty-free when you’re 59 ½ or older. (With a Roth, the account must also have been opened for at least five years.)

This is important: In many cases, if you take money out before the age of 59 ½, the early withdrawal (or “distribution”) could trigger a 10% penalty. And you may have to pay federal (and state, if applicable) taxes on top of it. But there are exceptions to this early distribution rule. You can visit IRS.gov or consult a tax professional for more information. 

Learn more: IRS 401(k) Resource Guide – General Distribution Rules

401(k) RMD rules

“Required minimum distribution” may sound a little intimidating. But it’s just IRS speak for the minimum amount of money you have to withdraw (or “distribute”) from certain types of retirement accounts each year after you’ve reached a specific age. In other words, you cannot keep your retirement money in a 401(k) account forever.

Both traditional and Roth 401(k) plans are subject to RMD rules. 

According to the IRS, if you have a 401(k), you usually have to start taking RMDs when you turn 72 (or age 70 ½ if you were born before July 1, 1949).

401(k)s are considered tax-advantaged investment accounts. In other words, putting money away in a 401(k) could offer potential tax benefits.

In some cases, if you’re still working at the company, you may not have to take RMDs from your 401(k) plan until you retire. It’s best to check directly with your 401(k) plan administrator if you have any questions about your RMD obligations. 

This is important: If you don’t take RMDs on time or in the correct amounts, you could end up paying a penalty. And this could be as much as 50% of the amount you were supposed to withdraw!

The IRS has a chart with more details on when you have to start taking RMDs and answers to frequently asked questions. If you have any specific concerns, you may also want to consult with a tax professional.

The wrap up

401(k)s can be a great tool to help you save for retirement. If your employer does offer a workplace plan, consider signing up and maximizing your contributions if you can. This could really give your retirement savings a boost, especially if there’s employer matching. And if you’re interested in learning more, check out our articles on The Importance of Having a 401(k) and 401(k) Rollovers.

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