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) offers 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.
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.
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 could save on taxes 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). Prior to the age of 59 ½, withdrawals of earnings are subject to income tax and a 10% penalty.
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.
401(k) investment options. When you sign up for a 401(k) plan, you can usually choose one or more investment options for your money. The number and variety of options will depend on your plan sponsor. 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.
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 on the table!)
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 when you leave the company.
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.
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 2023 tax year, you can stash up to $22,500 in your 401(k) plan. And for 2022, you can contribute up to $20,500.
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 $7,500 in 2023 ($6,500 in 2022) bringing your 2023 maximum contribution to a total of $30,000 ($22,500 + $7,500) and your 2022 maximum contribution to a total of $27,000 ($20,500 + $6,500). Nice!
Good to know: 401(k) maximum contribution limits are subject to change. Visit the IRS for the most up-to-date information.
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.
“Required minimum distributions”, or RMDs, 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. But note that starting in 2024, RMD rules do not apply to Roth 401(k) plan participants while they are alive (but their beneficiaries may have to take RMDs after the account owner’s passing).
Keep in mind that RMDs are required by the IRS, and failure to take RMDs may result in penalties. Visit the IRS website for more information on RMDs. If you have questions about your specific situation, consult with your financial advisor or a tax professional.
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 article 401(k) Rollovers.
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