What Is a 401(k) Plan?

A 401(k) is an employer-sponsored retirement plan. If an employer offers a 401(k) as part of their benefits package, employees can choose to contribute a portion of their wages to fund a 401(k) account—subject to annual limitations—and the employer may opt to match a portion of an employee’s contributions. Employees can choose to invest the funds saved in their 401(k) account in one or more mutual funds offered by the plan, and take distributions from the account to provide them with income in retirement.

How Does a 401(k) Work?

A 401(k) is a defined contribution retirement plan, which means that employees decide how much to contribute to the plan. The unintuitive name comes from the section of the Internal Revenue Code that governs the plans. Two kinds of 401(k) accounts may be offered by employers: Traditional 401(k)s funded by pre-tax income, and Roth 401(k)s funded by post-tax income.

Taxes and Your 401(k)

Contributions to a traditional 401(k) plan are taken out of your paycheck before income taxes are calculated. This means that contributions help lower your taxable income immediately. The contributions are invested in mutual funds and other investments, and grow in value over time. When you take money out of your traditional 401(k) in retirement, you pay ordinary income tax on the withdrawals.

You can also choose a Roth 401(k)

Many 401(k) plans give participants the option to choose a Roth 401(k). With a Roth 401(k), you make contributions to your plan with after-tax income, meaning the contributions do not reduce your taxable income. Like a Roth individual retirement account (IRA), you pay no income taxes on qualified distributions, such as those made after the age of 59 ½ (assuming you’ve held the account for five years).

Choosing a Roth 401(k) can make sense if you believe you will be in a higher tax bracket when you retire than you are today. For many young earners who are just beginning their careers, lower income levels and tax brackets could make a Roth 401(k) a great choice.

There is nothing forcing you to choose between either a traditional 401(k) or a Roth 401(k)—you can make contributions to both kinds of 401(k) plan, if your employer offers them. Consider speaking with a tax professional or a financial advisor when deciding between a traditional or a Roth 401(k), or dividing your contributions between both types.

How Do 401(k) Contributions Work?

You decide how much of your income to contribute to a 401(k) account every year, subject to IRS limits. Generally you elect to save a percentage of your annual salary in your employer’s 401(k) when you start a new job, and you can adjust your contribution level up or down as often as the rules of the plan allow. You may halt contributions entirely at any time, for any reason.

Let’s say your bi-monthly paycheck is $2,000, and you chose to contribute 5 percent of your annual salary in the company’s traditional 401(k) plan. In this case, $100 would be subtracted from each paycheck and deposited in your 401(k) account. Your taxable income would be $1,900 (assuming no other pre-tax deductions). If you opted for a Roth 401(k), the $100 would be taken out of each paycheck after taxes.

Depending on your employer’s plan, you may be automatically enrolled in a 401(k) plan at a set contribution rate when you start a job, unless you choose to opt-out of the plan. Alternatively, you may need to affirmatively choose whether to enroll in your employer’s 401(k) plan or opt-out.

How Do Employer 401(k) Matching Contributions Work?

Some employers offer to match their employees’ 401(k) contributions, up to a certain percentage of their salary. One common approach involves an employer matching employee contributions dollar-for-dollar up to a total amount equal to 3 percent of their salary. Another popular formula is a $0.50 employer match for every dollar an employee contributes, up to a total of 5 percent of their salary.

Continuing our example from above, consider the impact on your 401(k) savings of a dollar-for-dollar employer match, up to 3 percent of your salary. If you contribute 5 percent of your annual pay and receive $2,000 every pay period, with each paycheck you would be contributing $100 and your employer would contribute $60.

When starting a new job, find out whether your employer provides matching 401(k) contributions, and how much you need to contribute to maximize the match.

If they do, you should at a minimum set your 401(k) contribution level to obtain the full match, otherwise you’re leaving free money on the table.

401(k) matching contributions and vesting

Some employers grant 401(k) matching contributions that vest over time. Under a vesting schedule, you gradually take ownership of your employer’s matching contributions over the course of several years. If you remain with the company for the entire vesting period, you are said to be “fully vested” in your 401(k) account.

Employers impose a vesting schedule to incentivize employees to remain with the company.

For example, imagine that 50% of your employer’s matching contributions vest after you’ve worked for the company for two years, and you become fully vested after three years. If you were to leave the company and take a new job after two years, you would pass up owning half of the matching contributions pledged by your employer.

Keep in mind, however, that you always maintain full ownership of contributions you have made to your 401(k). Vesting only involves the employer’s matching contributions.

Annual 401(k) Contribution Limits

For tax year 2020, the maximum an employee can contribute to a 401(k) is $19,500. If you’re 50 or older, you can deposit an extra $6,500 in catch-up contributions, for a combined contribution of $26,000. These limits apply to all 401(k) contributions, even if you split them between pre-tax and Roth contributions, or you have two employers in a year and thus two separate 401(k) accounts.

About a fifth of employers also allow after-tax, non-Roth contributions. In such cases, a combined employee and employer contribution limit applies. In other words, your employer’s contributions, combined with your pre-tax, Roth and after-tax contributions, can’t exceed this limit. For 2020, that combined limit is $57,000, or $63,500 for those 50 or older. Unlike Roth contributions, these extra after-tax savings grow tax deferred, but not tax free.

The contribution limits are updated as frequently as annually based on inflation, so it’s important to check back to see if you can increase your contribution if you’ve been contributing the maximum.

Choosing Investments in Your 401(k)

You will usually have several investment options in your 401(k) plan. The plan administrator provides participants with a selection of different mutual funds, index funds and sometimes even exchange traded funds (ETFs) to choose from.

You get to decide how much of your 401(k) balance to invest in different funds. You could opt to invest 70 percent of your contributions in an equity index fund, 20 percent in a bond index fund and 10 percent in a money market mutual fund, for example.

Plans that automatically enroll workers almost always invest their contributions in what is known as a target-date fund. That’s a fund that holds a mix of stocks and bonds, with the mix determined by your current age and your “target” date for retirement. Generally, the younger you are, the higher the percentage of stocks. Even if you are automatically enrolled in a target-date fund, you are always free to change your investments.

Investing options available in 401(k) plans vary widely. You should consider consulting with a financial adviser to help you figure out the best investing strategy for you, based on your risk tolerance and long-term goals.

Withdrawing funds from your 401(k)

Funds saved in a 401(k) are intended to provide you with income in retirement. IRS rules prevent you from withdrawing funds from a 401(k) without penalty until you reach age 59 ½. With a few exceptions (see below), early withdrawals before this age are subject to a tax penalty of 10% of the amount withdrawn, plus a 20% mandatory income tax withholding of the amount withdrawn from a traditional 401(k).

[Note: The CARES Act allows eligible 401(k) participants younger than age 59 ½ to take an early distribution of up to $100,000 during calendar year 2020 without paying the 10% tax penalty. Note that this is $100,000 in total, per person, no matter how many retirement accounts you have.]

After you turn 59 ½, you can choose to begin taking distributions from your account. You must begin withdrawing funds from your 401(k) at age 72 (or age 70 ½ if you were born before June 30, 1949—the SECURE act increased this age threshold), as required minimum distributions, or RMDs.

How do 401(k) required minimum distributions (RMDs) work?

Holders of both traditional 401(k)s and Roth 401(k)s are required to take RMDs. The amount of your RMDs is based on your age and the balance in your account. As the name suggests, an RMD is a minimum—you can withdraw as much as you wish from the account each year, either in one lump sum or in a series of staggered withdrawals. As noted above, RMDs from a traditional 401(k) are included in your taxable income, while RMDs from Roth 401(k)s are not.

[Note: The CARES Act has suspended required minimum distributions for 2020.]

How to avoid 401(k) early withdrawal penalties

There are certain exceptions that allow you to take early withdrawals from your 401(k) and avoid the 10% early withdrawal tax penalty if you aren’t yet age 59 ½. Some of these include:

• Medical expenses that exceed 10% of your adjusted gross income
• Permanent disability
• Certain military service
• If you leave your employer at age 55 or older
• A “Qualified Domestic Retirement Order” issued as part of a divorce or court-approved separation.

Even if you can escape the additional 10% tax penalty, you still have to pay taxes on your withdrawal from a traditional 401(k).  (In the case of a distribution paid to an ex-spouse under a QDRO, the 401(k) owner owes no income tax and the recipient can defer taxes by rolling the distribution into an IRA.)

401(k) Loans

Some 401(k) plans let you borrow against your 401(k) balance. It’s possible to borrow up to $50,000 or 50% of your vested balance, whichever is less. You generally have five years to repay your loan, and you’ll be charged interest and origination fees—although the interest goes back into your 401(k).

If you fail to pay back the loan after five years, the IRS considers it a distribution, subject to taxes and that 10 percent tax penalty. If you leave your job or lose your job, the plan sponsor may require the employee to repay the outstanding balance immediately and if you don’t, the sponsor will report it to the IRS as a distribution.  However, you have until October of the next year–the due date of your tax return with extensions–to deposit the loan balance in an IRA and avoid owing any immediate tax or penalty.

[Note: The CARES Act increases the loan limit to 100% of the vested balance or $100,000, whichever is less This option is available for any loans taken out during the six-month period from March 27, 2020 to September 23, 2020. Under the act, borrowers may forgo repayment during 2020, with the five-year repayment period beginning in 2021—giving borrowers an extra year to repay their loans.]

What happens to your 401(k) when you change jobs?

You have several options for your 401(k) balance when you change jobs. Avoid simply cashing out your savings—if you’re under 59½ years old, you’ll get hit with the 10 percent early withdrawal tax penalty, and if it’s a traditional 401(k) you’ll own income tax on the balance.

If you have less than $1,000 in your 401(k), the plan administrator is empowered to write you a check for the balance. This gives you 60 days to reinvest the money in an IRA or your new company’s 401(k) plan before you are subject to the additional 10% tax penalty and possible ordinary income tax. If you have more than $1,000 but less than $5,000 in your 401(k), the administrator can open an IRA in your name and roll your balance over into it.

Leave your 401(k) with your old employer

Some 401(k) plans let you leave your money right where it is after you leave the company. However, as you move through your career, this means you will need to keep track of multiple 401(k) accounts. Some employers require you to withdraw or roll over your 401(k) balance within a set period of time after you’ve left your job.

Move your 401(k) into your new employer’s plan

In some cases you can roll your old 401(k) balance over into your new employer’s plan, although not all plans allow this. Find out from your new employer whether they accept a trustee-to-trustee transfer of funds and how to handle the move. Make sure you understand the tax treatment of your 401(k) balances. Make sure that traditional 401(k) funds are rolled into a traditional 401(k) and Roth funds end up in a Roth account.

Roll your 401(k) balance into IRA

Another possibility is for you to roll the balance over into an IRA. When moving the money, make sure you initiate a trustee-to-trustee transfer rather than withdrawing the funds and then depositing them into a new IRA. Many IRA custodians allow you to open a new account and designate it as a rollover IRA so you don’t have to worry about contribution limits or taxes. When rolling your 401(k) balance into an IRA, make sure you place traditional 401(k) funds in a traditional IRA, and Roth funds in a Roth IRA.