How a 401(k) Works
How Does the 401(k) Work?
A 401(k) plan usually consists of three components: employee deferrals, employer contributions, and investment options.
Under a traditional 401(k), employees choose how much to contribute from their paychecks each month. Their choices might be limited to a certain percentage of their income. How much employees contribute is not subject to federal taxes; the employees’ paychecks are adjusted accordingly and all contributions go into the 401(k) account.
Employers also make contributions, usually as a percentage of the employees’ salaries, but can offer other options such as matching a certain percentage of an employee’s contributions up to a certain amount or contributing a flat dollar amount for each pay period in which the employee contributes. Contributions may consist entirely of pre-tax dollars or part may be made with after-tax dollars.
To invest their money, employees typically choose specific funds within the 401(k) plan, like a target-date fund or a balanced fund. This way the employee doesn’t have to manage this part of their retirement savings and can leave it to a professional financial manager who has access to a wide range of investment choices.
Who Can Contribute to a 401(k)?
Anyone who has a 401(k) plan at their job can contribute. If an employer offers a match, that contribution is free money, and it’s in the worker’s best interest to take advantage of that extra savings. The following conditions apply:
- You must be employed (working for pay)
- You must be age 18 or older
- You must have earned income from working for someone else or as a self-employed individual
If you’re married, your spouse can also contribute to a 401(k) even if he/she has another job where there is no employer match.
Similar to taxes on traditional IRA accounts, contributions made to a traditional 401(k) plan are not deductible on a person’s federal income tax return.
What Are the Benefits of Having a 401(k)?
401(k) plans have been around since 1978. They have become popular as an alternative to the IRA because they offer several benefits:
- Contributions made to a 401(k) account are NOT subject to federal taxation until the money is distributed.
- Employers often match employees’ contributions, offering free money towards retirement.
- Some traditional 401(k) plans allow for variable investments like stocks, bonds, and mutual funds through a professional financial services firm (this may require additional paperwork).
- You can invest in mutual funds instead of setting up an IRA account at a financial institution where fees may be higher.
- You can take money out at any time, but if you withdraw before reaching retirement age, there may be penalties for early withdrawal (including taxation).
- 401(k)s are not subject to required minimum distributions (RMDs) during the lifetime of the plan owner.
What Are Some Drawbacks of Having a 401(k)?
- If you withdraw money from a 401(k) before age 59 1/2, you will be assessed an early withdrawal penalty and your earnings on the withdrawal will be taxed as ordinary income.
- Employers might use high-commission investments for their plans that may not be in the best interest of employees.
- Vesting requirements for employees mean some people may not receive the full employer match because they haven’t been employed there long enough.
- High administrative fees can eat into your retirement savings, and some 401(k) plans only offer a limited number of investment options from which to choose.
- If you’re self-employed, you’ll need to file a special tax form (5498-MSA) each year that you have a traditional 401(k); you also can’t deduct your contributions on your federal income tax return.
401(k) Plan | A Complete Beginner's Guide
The 401(k) retirement savings account got its name from the Revenue Act of 1978, where an addition to the Internal Revenue Services (IRS) code was added in section 401(k). Consequently, 401(k) does not stand for anything except for the section of IRS tax code it was created in.
Traditional 401(k) vs Roth 401(k)
There are two types of 401(k) plans: Traditional and Roth 401(k)s. The traditional 401(k), named after the relevant section of the IRS code, has been around since 1978. With this plan, any contributions you make to the 401(k) account will reduce your income taxes for that year and will be taxed when they are withdrawn. Roth 401(k)s, named after former senator William Roth of Delaware, were introduced in 2006. Unlike a traditional 401(k), all contributions are made with after-tax dollars and the funds in the Roth 401(k) account accrue tax free. Typically, employees can take advantage of both plans at the same time, which is recommended among financial advisors to maximize retirement savings. Because of the way the contribution limits work, it is possible to invest different amounts into each account, even year-to-year, so long as the total contribution does not exceed the set limit.
Contributing to Your 401(k) Retirement Plan
Contributing to a 401(k) plan is traditionally done through one’s employer. Typically, the employer will automatically enroll you in a 401(k) that you may contribute to at your discretion. If you are self-employed, you may enroll in a 401(k) plan through an online broker, such as TD Ameritrade. If your employer offers both types of 401(k) accounts, then you will most likely be able to contribute to either or both at your discretion. To reiterate, with a traditional 401(k), making a contribution reduces your income taxes for that year, saving you money in the short term, but the funds will be taxed when they are withdrawn. With a Roth 401(k), your contributions can be made only after taxation, which costs more in the short term, but the funds will be tax free when you withdraw them. Because of this, deciding which plan will benefit you more involves figuring out in what tax bracket you will be when you retire. If you expect to be in a lower tax bracket upon retirement, then a traditional 401(k) may help you more in the long term. You will be able to take advantage of the immediate tax break while your taxes are higher, while minimizing the portion taken out of your withdrawal once you move to a lower tax bracket. On the other hand, a Roth 401(k) may be more advantageous if you expect the opposite to be true. In that case, you can opt to bite the bullet on heavy taxation today, but avoid a higher tax burden if your tax bracket moves up. Check out this article from Forbes to see the IRS tax rate tables for 2020, but remember that they are subject to change. A smart move may be to hedge your bets and divide your contributions between the two types of IRAs. If your employer allows you to add funds to both a traditional and Roth 401(k), then doing so reduces the potential risks of each. In this case, you will also have the ability to decide what proportion of your income goes into each account, meaning that as you near retirement and have a clearer idea of what position you will be in, you can put more into one or the other. When you do decide which avenue to take, make sure to thoroughly evaluate your decision. Moving funds from one account to another, such as from a traditional to a Roth 401(k), is time consuming and expensive, if even possible. Likewise, transferring a 401(k) from one employer to another in the event of a job change is also tricky. You want to make sure that when you put money into your plan, it will be able to sit undisturbed for a very long time.
Pension vs 401(k)
Pensions are similar to a 401(k), but are a liability to a company. If an employer offers an employee a pension, it means that they are promising to pay out a set amount of money to the employee at the time of their retirement. There is typically no option to grow this amount, but it also does not require any financial investment from the employee. Pensions, also referred to as defined-benefit plans, are becoming increasingly rare because it puts the financial burden of offering a retirement fund for employees entirely on the employer. 401(k)s, which are also called defined-contribution plans, take some of the financial pressure off of an employer, while also allowing employees to potentially earn a larger retirement package than they would have with a pension.
How Much Should I Contribute to My 401(k)?
Most financial experts say you should contribute around 10%-15% of your monthly gross income to a retirement savings account, including but not limited to a 401(k). There are limits on how much you can contribute to it that are outlined in detail below. There are two methods of contributing funds to your 401(k). The main way of adding new funds to your account is to contribute a portion of your own income directly. This is usually done through automatic payroll withholding (i.e. the amount that you wish to contribute, counting all adjustments for taxation, is simply withheld when receiving payment and automatically put into a 401(k)). The system mandates that the majority of direct financial contributions will come from your own pocket. It is essential that, when making contributions, you consider the trajectory of the specific investments you are making to increase the likelihood of a positive return. The second method comes from deposits that an employer matches. Usually employers will match a deposit based on a set formula, such as 50 cents per dollar contributed by the employee. However, employers are only able to contribute to a traditional 401(k), not a Roth 401(k) plan. This is especially important to keep in mind if you want to utilize both types of plans. A key variable to keep in mind is that there are set limits for how much you can add to a 401(k) in a single year. For employees under 50 years of age, this amount is $19,500, as of 2020. For employees over 50 years of age, the amount is $25,000. If you have a traditional 401(k), you can also elect to make non-deductible after-tax contributions. The absolute limit, counting this choice and all employer contributions, is $57,000 for employees under 50, and $63,000 for those over 50 as of 2019.
Plan in Advance
401(k) Plan FAQs
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.