What is a 401(k) plan and how does it work?
A 401(k) is a retirement savings and investing plan that employers offer. A 401(k) plan gives employees a tax break on money they contribute.
Contributions are automatically withdrawn from employee paychecks and invested in funds of the employee’s choosing (from a list of available offerings). The accounts have an annual contribution limit of $22,500 in 2023 ($30,000 for those age 50 or older).
The catchy name comes from the section of the tax code — specifically subsection 401(k) — that established this type of plan.
Employees contribute money to an individual account by signing up for automatic deductions from their paycheck. Depending on the type of plan you have, the tax break comes either when you contribute money or when you withdraw it in retirement.
If this is the point at which you dozed off during employee orientation, you may have missed the best part — sometimes there’s free money involved.
How do you get a 401(k)?
You get a 401(k) from your employer.
Many employers offer to match a portion of what you save, and the perk that gets all the headlines is the employer match.
If you work somewhere that offers to toss extra money into your account based on how much you contribute — for example, a dollar-for-dollar or 50-cents-on-the-dollar match up to, say, 6% of your contribution amount — stop reading now and consider filling out the paperwork. If you do nothing else, think about contributing enough to your account to nab that free money.
One benefit of a 401(k) is it automates saving for retirement and makes investing a bit easier. You can choose your investments from your plan’s selection, or you can let the plan choose for you. If you want, let’s say a certain percentage of stocks versus bonds, you can request that. The plans generally have automatically rebalancing, so those percentages stay in line with what you requested.
Play around with our to see how your savings will grow tax-free with a 401(k) — and the difference incremental changes, including any company match, will make over time.
Unfortunately, the investment selections in 401(k) plans can be limited. And, not all employers offer access to a 401(k) plan. But you can still reap the same tax benefits from the other big retirement savings vehicle – an individual retirement account.
What is an IRA? These accounts offer some attractive benefits (a broader selection of investments and generally lower fees), albeit with a few downsides (lower contribution limits and restrictions for high earners). Here’s how a 401(k) differs from an IRA and, if applicable, how to take advantage of both at the same time.
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Types of 401(k)
This is a good time to mention there are several types of 401(k) plans, including the two main kinds: the traditional 401(k) and the Roth 401(k). The traditional (or regular) 401(k) offers an upfront tax break on your savings. Contributions to a Roth 401(k) are made with after-tax dollars, so you don’t get to deduct the money from that year’s taxes. But don’t worry; the Roth’s payoff comes later. Here’s more on the differences.
Contributions to a traditional 401(k) plan are taken out of your paycheck before the IRS takes its cut, and your money grows tax-free. Let’s say Uncle Sam normally takes 20 cents of every dollar you earn to cover taxes. Saving $800 a month outside of a 401(k) requires earning $1,000 a month — $800, plus $200 to cover the IRS’ cut. (Here are the contribution limits to shoot for this year.)
Besides the boost to your savings power, pretax contributions to a traditional 401(k) have another nice side effect: They lower your total taxable income for the year. For example, let’s say you make $65,000 a year and put $19,500 into your 401(k). Instead of paying income taxes on the entire $65,000 you earned, you’ll only owe on $45,500 of your salary. In other words, saving for the future lets you shield $19,500 from taxation.
Once money is in your 401(k), the force field that protects it from taxation remains in place. This is true for both traditional and Roth 401(k)s. As long as the money remains in the account, you pay no taxes on any investment growth. Not on interest. Not on dividends. Not on any investment gains.
But the tax-repellent properties of the traditional 401(k) don’t last forever. Remember when you got that tax deduction on the money you contributed to the plan? Well, eventually the IRS comes back around to take a cut. In technical terms, your contributions and the investment growth are tax-deferred — put off until you start making withdrawals from the account in retirement. At that point, you’ll owe income taxes.
Here’s where the Roth 401(k)’s superpower is revealed.
If your employer offers a Roth 401(k) – and not all do – you can contribute after-tax income and your distributions will be tax-free in retirement.
The Roth 401(k) offers the same tax shield as a traditional 401(k) on your investments when they are in the account; you owe nothing to the IRS on the money as it grows. But unlike with qualified withdrawals from a regular 401(k), with a Roth, you owe the IRS nothing when you start taking distributions.
How’s that, exactly? Remember we mentioned earlier that, depending on the type of 401(k) plan, you get a tax break either when you contribute or when you withdraw money in retirement? Well, the IRS can charge you income taxes only once.
You’ve already paid your due because your contributions were made with post-tax dollars. And any income you get from the account – dividends, interest or capital gains – grows tax-free, and when you withdraw money in retirement, you and Uncle Sam are already settled up.
Both the Roth and traditional 401(k)s have rules around withdrawals. There are a few exceptions, but in general, the IRS says you cannot take distributions from your account until age 59½ without running into additional taxes or penalties. Starting in 2024, plan participants will be able to make a hardship withdrawal for emergency expenses of up to $1,000.
» Still not sold on investing? Learn how inflation can impact your savings — and how investing can boost it — with our inflation calculator.
Because of rising inflation, the amount you can contribute annually to your 401(k) plans has also increased. In 2022, individuals could contribute $20,500; that number rose to $22,500 in 2023. For people 50 and up, the new limit is even bigger – it’s $30,000 in 2023, versus $27,000 in 2022.
And if you are not participating in your company’s 401(k) plan, take note. Under a spending bill signed by President Biden, starting in 2025, employers will be required to automatically enroll participants in 401(k) and 403(b) plans once employees are eligible.
The automatic contribution starts at at least 3%, but not more 10%. The contributions taken out of your paycheck will increase by 1% a year until your annual contribution is at least 10%, but not more than 15%. The legislation says all current 401(k) and 403(b) plans are grandfathered.
Another big benefit of the 401(k) is that the money is all yours, and it’s portable. If you leave your job for another, you can take your 401(k) with you. To avoid hefty taxes and fees, you’ll need to convert that account into a new one — and for many people, rolling your 401(k) over to an IRA is a great idea.