- A 401(k) is an employer-sponsored retirement plan with tax advantages, employer matching opportunities, and high contribution limits.
- While the traditional, pre-tax 401(k) is the most popular type of plan, many employers now offer a post-tax, Roth 401(k) option.
- When you sign up for a 401(k), you set aside a portion of each paycheck, before or after taxes, to go directly into the investment accounts you choose and grow tax-deferred until retirement.
- Generally, it’s best to wait until retirement age to withdraw 401(k) funds, and these withdrawals will be taxed as ordinary income based on which kind of account(s) you have.
A 401(k) is a popular employer-sponsored retirement plan. With high contribution limits, tax advantages, and employer matching opportunities, it’s one of the best options many Americans have to grow their retirement savings.
Since their inception in 1978, 401(k)s have become a common feature in many benefits packages, allowing employees to easily set aside a portion of each paycheck toward their retirement goals. As of 2020, around 60 million U.S. workers and retirees had active 401(k) plans.
If your employer offers a 401(k), deciding whether to opt-in is a key part of the onboarding process. But it’s also important to know how these plans work when it comes to contributions, investment decisions, changing jobs, and preparing to draw funds during retirement.
How Does A 401(k) Work?
Named after a section of the IRS code, 401(k)s are a great way to save for retirement because they allow you to set aside a portion of your paycheck, along with any employer matching funds. Most 401(k)s are pre-tax, meaning your contributions are tax-deductible and grow tax-deferred until you withdraw them in retirement.
Your specific 401(k) plan will offer a set of investment options — stocks, bonds, mutual funds and more — that you can choose from. As you make contributions, you can decide how you want to allocate the money based on how close you are to retirement and how comfortable you are with risk. Generally, you shouldn’t withdraw funds until you reach retirement age (59 ½), as you’ll face tax penalties and other potential fees.
You can only access a 401(k) through your employer, so you’ll have to be sure your employer offers one before you can join. They also come in two different forms, and there are rules for contribution limits, taxes and withdrawals, which we’ll explore in detail below.
Employer Matching And Vesting
Employer matches offer one of the biggest benefits of 401(k)s, as they offer a way to substantially improve your returns. They’re usually structured to match your contributions at a certain rate up to a certain amount. These amounts vary by employer, but a typical setup would be something like 50 cents per dollar up to 4.5% of an employee’s salary.
Say you make $100,000. In the above scenario, your employer would put in 50 cents for every dollar you contribute to your 401(k) until you’ve contributed $4,500 (4.5%) of your total salary. After that, any contributions you make would not receive a match. So, you could receive up to $2,250 in matching contributions if you contribute at least $4,500 to your plan. If you contribute less than that, you’re essentially leaving money on the table.
The employer match can be an attractive 401(k) feature when considering a job offer. However, it’s important to understand vesting before making a decision. Many employers set a vesting schedule for their contributions, which means you don’t actually own their contributions or associated earnings right away.
Often, vesting schedules are graded over a set period. You might get 20% vested for each year of employment, meaning you won’t be fully vested until you’ve been working and receiving matches for five years. If you leave the company before that time, you’ll lose any unvested funds and associated earnings.
Main Types Of 401(k) Plans
Historically, 401(k) contributions were all made pre-tax. However, that changed in 2006, when the Roth 401(k) was introduced. Now, many employers allow employees to choose one or both of these options.
Traditional 401(k)
The traditional 401(k) is what most people are familiar with as a retirement savings tool. With this type of account, any money you set aside comes out of your paycheck before it’s taxed. This lowers your taxable income, allowing you to put more of your earnings toward retirement or other savings goals.
Any money in your traditional 401(k) will grow tax-deferred, so you don’t pay any income or capital gains taxes on your earnings until you begin withdrawing funds. As you withdraw the money during retirement, you’ll pay ordinary income taxes on your withdrawals, based on your tax bracket at that time.
Roth 401(k)
Roth 401(k) plans offer you a different option. With this type of account, you make after-tax contributions. Any money you earn on these contributions is also tax-free, so you won’t pay any taxes when you withdraw money in retirement. Note, however, that any employer contributions and associated earnings will still be taxed as ordinary income at the time of withdrawal.
For most people, a traditional 401(k) makes the most sense. However, a Roth 401(k) may be a suitable option if you expect to be in a higher tax bracket during retirement. You may even want to contribute to both types of accounts in some situations.
Understanding 401(k) Contributions
Aside from tax questions, there are other important considerations when it comes to contributions. For both your own contributions and your employer match, certain rules apply.
Employee Contribution Limits
Unfortunately, you can’t contribute your entire paycheck to a 401(k) to avoid all income-tax liabilities. The IRS imposes a limit on employer contributions — also known as elective deferrals. This amount changes based on cost of living increases. In 2023, the maximum amount you can contribute to a 401(k) is $22,500. If you’re age 50 or older, you can make an additional catch-up contribution of up to $7,500 in 2023.
If you exceed these limits, you’ll end up paying taxes on the excess amount twice — once in the year you made the contributions and once when you withdraw them. However, you can avoid this penalty if you catch the mistake and withdraw the excess funds before taxes are due for that year.
Total Contribution Limits
A 401(k) plan is also subject to total contribution limits, which include any employer contributions. In 2023, total 401(k) contributions cannot exceed $66,000 (not including the $7,500 in additional catch-up contributions).
This limit applies to all your 401(k) accounts. So, if you have a traditional and a Roth 401(k), you and your employer can only contribute a total of $66,000 to both, not $66,000 to each.
401(k) Withdrawal Rules
As you approach retirement age, it’s important to know the rules around withdrawing funds from your 401(k). These withdrawals are known as distributions, and handling them properly will set you up to maximize your retirement benefits.
Ensuring Qualified Distributions
Withdrawals that meet the IRS criteria to avoid any penalties are known as qualified distributions. To take qualified distributions, you must either:
- Reach age 59 ½
- Experience financial hardship (defined as immediate and heavy financial need, determined on a case-by-case basis)
- Die, become disabled or lose employment
- Have a plan that terminates without your employer defining and maintaining any defined contribution plan
Although there are a few exceptions, generally, if you or your beneficiaries take distributions without meeting one of these criteria, you’ll pay an extra 10% tax on those distributions. You can avoid this tax if you meet hardship qualifications, but you must limit withdrawals to only your elective deferrals — what you originally put into the plan — not any earnings. Note, also, that Roth 401(k) withdrawals are off-limits for the first five years you invest in the plan.
Some 401(k) plans also allow you to take loans from your vested account balance. If your plan includes this option, you can borrow up to $50,000 or 50% of your account balance, whichever is less. Unless the loan is used to pay for your primary residence, you’ll need to repay it within five years to avoid penalties.
Taxes On Distributions
Taxation on your distributions depends on which type of 401(k) you have. Your Roth 401(k) contributions and earnings are not taxable at the time of distribution, although any employer contributions and earnings are. All funds in a traditional 401(k) are taxable as ordinary income at the time of distribution, so it’s important to plan your distribution schedule in conjunction with any other income sources in retirement. The IRS will add all taxable retirement income together to determine your tax bracket.
Required Minimum Distributions
All 401(k) accounts are subject to required minimum distribution (RMD) rules, meaning that you must begin withdrawing minimum amounts once you retire or reach a certain age. These minimum amounts are determined by your employer under IRS guidelines.
The age limit for postponing withdrawals varies based on when you were born. As of 2023, RMDs must begin no later than April 1 of the year after you turn 73. However, you’ll need to take RMDs when still working at:
- Age 70 ½ if you hit this mark before Jan. 1, 2020
- Age 72 if you hit this mark before Jan. 1, 2023
If you continue working past the RMD age, you must begin taking distributions by April 1 of the tax year after you retire. However, your specific plan rules may force you to begin taking withdrawals as of your RMD age, regardless of whether you continue working.
How To Set Up And Maintain A 401(k)
Setting up a 401(k) is relatively simple, but it takes a few steps when you begin a new job.
- Find out if your employer offers a 401(k). This is really a step you should take before you accept a job. If a 401(k) is an important part of a benefits package, be sure your would-be employer offers one and that its matching and vesting requirements suit your retirement goals.
- Decide which type to use. If your employer offers traditional and Roth 401(k) options, speak with a financial advisor to decide which would be best — or even if you would benefit from funding both.
- Determine how much to contribute. Generally, it’s best to fund your 401(k) up to the maximum amount your employer will match. After that, you may want to explore other investing and savings options to balance your retirement investing strategy before returning to your 401(k) with any leftover funds.
- Choose your investment strategy. Your 401(k) investing strategy should be based on how close you are to retirement. In general, the further you are from retirement age, the more aggressive you can afford to be. If you have any questions about the best approach, talk to your plan administrator or a trusted financial advisor.
- Make adjustments as your circumstances change. Retirement investing is not a “set it and forget it” task. As your salary changes, your family grows or you get closer to retirement, you’ll need to make adjustments. Revisit your plan annually to make sure your current strategy suits your long-term goals.
What Happens To A 401(k) When You Change Jobs?
Since 401(k)s are employer-based, job changes are an important consideration when you sign up for this type of plan. Although you can’t continue investing in the same 401(k) when you leave your job, you have a few options.
You can, of course, withdraw the money, but this is generally a bad idea if you haven’t reached retirement age. A better option is to roll the old 401(k) into a new 401(k) with a new employer or into an IRA. There are strict rules about this, but If you do it correctly — under the guidance of the new plan administrator or an advisor — you can avoid any tax consequences.
Alternatively, you may be able to leave the money in your old employer’s 401(k). However, be sure you’re comfortable with the plan’s management and investing options — and that you won’t lose track of any old 401(k) plans as you move along in your career.
Is A 401(k) Right For You?
Even if your employer offers a 401(k), it’s by no means the only retirement savings option to consider. Traditional IRAs offer similar tax-advantaged savings opportunities without the advantage of employer matching and high contribution limits. Roth IRAs, meanwhile, do the same in comparison to a Roth 401(k). A sound retirement plan may include a mix of these and other savings tools.
Generally speaking, however, if your employer offers a 401(k) with a match and a reasonable vesting schedule, it’s one of the best places to put your money for retirement. Most financial experts recommend that you fund your 401(k) up to your employer’s maximum match before exploring other retirement investing options. From there, it’s about finding the best mixture of investing choices to minimize your long-term tax liabilities.
Frequently Asked Questions (FAQs)
What’s The Difference Between A 401(k) And A 403(b)?
Depending on your employer, you may encounter alternatives to a 401(k), such as a 403(b) or a 457(b). These plans function similarly to 401(k)s but are offered by government organizations, schools and certain nonprofits.
What Are The New 401(k) Hardship Withdrawal Rules?
The SECURE 2.0 Act, which was signed into law in late 2022, added some additional provisions for hardship withdrawals. Participants can now withdraw funds before retirement age if a physician certifies that they have a terminal illness or other condition that could result in death in 84 months or less. Hardship withdrawals will also be expanded to victims of domestic abuse in 2024. Beginning in 2026, the legislation adds provisions for using funds to pay certain long-term care premiums.
