Home Investing What is a 401(k) Plan? A Comprehensive Guide

What is a 401(k) Plan? A Comprehensive Guide

Table of Contents

What Is a 401(k) Plan?
How a 401(k) Works
How Do You Get a 401(k)?
401(k) Withdrawals
Can I Withdraw Early?
401(k) Employer Matching
401k Distributions
401k Rollovers
Types of 401(k)s and Retirement Accounts
401(k) FAQs
Next Steps for You

Contributing to a 401(k) is extremely valuable as you plan your long-term retirement goals. Over time, you can develop investment strategies in order to optimize your 401(k).

Here, we’ll cover key aspects of how your 401(k) can contribute to your nest egg, whether you’re just getting started or are nearing retirement.

What Is a 401(k) Plan?

One of the most common investment vehicles, a 401(k) plan is a tax-advantaged, employer-sponsored plan that allows you to save for retirement in a tax-sheltered way to help maximize your retirement dollars. Sometimes, your employer may even contribute to your plan.

How a 401(k) Works

Typically, you have income taxes withheld from the money you earn as an employee. A 401(k) plan allows you to accomplish two goals:

Invest your money for retirement
Avoid paying income taxes in the current year on the amount of money that you put into the plan, up to the 401(k) contribution limit

The money grows tax-deferred inside the plan, meaning you don’t have to pay tax on gains until you take money out of the plan.

The most you can invest in your 401(k) depends on your plan, your salary, and government guidelines. This IRS-set limit is $19,500 in 2021 and $20,500 in 2022.

How Do You Get a 401(k)?

401(k) plans are only offered by employers. So if you don’t have access to a 401(k) at your workplace, you can’t participate in one. Talk to your human resources department to find out whether your company offers a 401(k) plan and, if so, how you can join.

If your company doesn’t offer a 401(k), that doesn’t mean you can’t reap 401(k)-style retirement and tax benefits. You can still open an IRA on your own. IRAs offer the same opportunity to save for retirement with tax advantages — the biggest difference is that annual IRA contribution limits are lower and there may be restrictions on higher earners.

401(k) Withdrawals

To begin, 401(k) plan rules may not allow you to take regular withdrawals unless one of several events has occurred. Some examples include turning age 59½ or leaving your job. You must meet certain requirements to avoid paying penalties.

Taking a distribution from your 401k prior to turning 59½ may cause you to owe federal income tax (taxed at your marginal tax rate), state income and other related tax, and a 10% penalty on the amount you withdraw. You may be able to withdraw penalty-free from your current employer’s 401(k) if you retire after age 55 from the employer where the plan is currently in place. Given these consequences, withdrawing from a 401(k) early is usually not ideal.

Once you reach the age of 59½, the IRS allows you to take penalty-free withdrawals from your retirement accounts. Due to the SECURE Act, Required Minimum Distributions (RMDs) are required after someone turns 72 years of age.

Can I Withdraw Early?

If you are in dire need of money, you may qualify to take 401(k) withdrawals depending on your situation and the plan’s rules.

One option is a loan from your retirement plan, which the IRS limits to either half the vested account balance or $50,000, whichever is less. The loan will need to be paid back, and does charge interest, though the interest goes into your account, so you are essentially paying yourself the interest. Various plans have different rules around plan loans, so reach out to your plan administrator for all the details.

Another option is known as “hardship withdrawals.” These are designed to let participants withdraw money from their employer retirement plans if they’re facing financial difficulty. Some hardship withdrawals may qualify for an exception from the 10% penalty, while others may not, but remember that pre-tax withdrawals almost always cause ordinary income tax. Some plans may also add restrictions following a hardship distribution, so check with the plan for details before taking action. Finally, remember that many distributions from employer plans have mandatory 20% withholding.

Pulling money from your employer’s retirement plan is usually not a good idea unless absolutely necessary.

Here are a few reasons why a hardship withdrawal could be allowed:

Medical expenses: A hardship withdrawal may be allowed if certain medical-related expenses are incurred by the plan participant or the participant’s spouse, dependents or beneficiaries. If the expenses are high enough, the distribution could qualify for an exception to the 10% penalty.
Home purchase and property damage: A hardship withdrawal may be allowed for expenses related to the purchase of a primary residence or certain repairs to the participant’s home.
Eviction or foreclosure: Hardship withdrawals can be allowed to help prevent eviction from or foreclosures on a primary residence.
Funerals: Expenses related to funerals for the participant, participant’s spouse, children, dependents or beneficiaries may qualify as a hardship withdrawal.
Education: Expenses such as tuition or room and board, fees for the next year of higher education for the plan participant, spouse, dependents or beneficiaries could qualify for a hardship withdrawal.
Disability: Though not technically a hardship distribution, disability as defined by the plan rules could allow for withdrawals that are exempt from the 10% penalty.
72(t) Distribution: As a last resort, a stream of 10% penalty-free annual payments can be taken from your 401(k) for either 5 years or until you reach age 59½, whichever is longer. There are multiple methods for calculating 72(t) distributions, so we recommend working with your tax advisor to find the most suitable option depending on your needs.

401(k) Employer Matching

Employer matching of your 401(k) contributions means that your employer contributes money to your retirement savings plan.

If you are not able to max out contributions, then try to contribute at least enough to take advantage of your employer’s matching contributions to your 401(k).

Here are the common types of employer matches.

Partial Match

Partial matches are when your employer will match part of the money you put into your 401(k), up to a certain amount. For example, your employer may offer a partial match of 50% of what you contribute, up to 6% of your salary. Let’s say you earn $100,000 per year. Your matching-eligible contributions are 6% of your salary, or $6,000. But since your company only offers a 50% partial match, they will match half of the $6,000, or $3,000. So to get the maximum amount of 401(k) match, you have to put in 6%. If you put in more, say 10%, your employer will still only match half of 6% of your salary. The employer has the ability to determine the matching parameters.

Dollar-for-Dollar Matching (100% Match)

Dollar-for-dollar matching is when your employer puts in the same amount of money you do, up to a certain amount. An example of dollar-for-dollar is up to 5% of your salary. In this case, if you put in 5%, they put in 5%; if you put in 2%, they put in 2%. If you put in 6%, they still only put in 5%, because that’s their maximum contribution.

Be sure to check on your company’s 401(k) vesting policy. While some employers immediately transfer the ownership of matched funds, others may delay the transfer several years in order to support employee retention.

401(k) Distributions

As you prepare for retirement, there are two key numbers you should always keep in mind: 59½ and 72.

When you approach the times in life when you are about to withdraw money for your retirement, be sure to understand the required minimum distributions (RMD) set by the IRS.

Here is something to keep in mind: RMDs do not have to be spent. They are required to be withdrawn from tax-deferred accounts starting with the year you reach age 72, but if you don’t need to spend the money, it makes a lot of sense to simply transfer it to your taxable brokerage account and invest it there.

If RMDs will likely increase your income tax bracket in retirement, you may want to consider a couple of strategies as you plan ahead for tax savings.

One idea is to withdraw or convert money from your tax-deferred accounts when you are in a low-income year. For example, doing a Roth conversion could make sense if it doesn’t increase your current tax bracket but would decrease a future tax bracket by decreasing the RMD amount. This is the type of calculation you should discuss with your financial advisor.

You also might want to consider using your RMD distribution as a charitable gift, which is commonly known as the qualified charitable distribution. The amount you give can help lower your tax bracket. Make sure to consult with your tax advisor before implementing this type of strategy.

401(k) Rollovers

Say for example you decide to leave your employer in the future. You may be inclined to just leave your money in the old employer’s 401(k) plan and not touch it as a way for you to have it “out of sight, out of mind.” Here are reasons to rethink that approach.

Do Not Leave It with Your Old Employer

While leaving money behind in a former employer’s 401(k) might be the easiest thing to do, it’s not always the best option. One of the main benefits of a 401(k) plan is an employer match if the company offers one. Once you leave a job where you have a 401(k), you no longer receive the company’s contribution or match. 401(k) plans tend to have high fees, limited investment options, and strict withdrawal rules. If the old 401(k) was rolled over to a different vehicle like a traditional or Roth IRA, you may have more control over the investment strategy.

Roll Over Your 401k Into a New 401(k) or IRA

If your new employer offers a 401(k) plan with low costs and a wide variety of investment options, this might be a viable option to consider. What could be an even better option though is to roll over your old plan into a Rollover IRA. 401(k)s can be costlier than IRAs, mostly if they come with an extra layer (or layers) of fees, and can be lacking in investment options like low-cost ETFs. You or your advisor can choose among thousands of ETFs, bonds, mutual funds or individual stocks in an IRA. Here’s a startling fact: By law, 401(k) plans can offer as few as three investment options. Mutual funds are not only expensive, but also tend to underperform the market. ETFs, on the other hand, provide a relatively low-cost, tax-efficient way to create a well-diversified portfolio. Low-cost investments help boost your retirement security – without having to ramp up savings or portfolio risk.

Types of 401(k)s and Retirement Accounts

Investing and saving for retirement is not a straightforward, easy task. There are endless variables such as life stages, personal goals, varying living costs, and different types of investment vehicles that can become overwhelming.

In addition to 401(k) options, there is a broad range of retirement investment vehicles:

traditional or Roth IRAs
Self-Directed IRAs
457 plans
403(b) plans

Read More: Types of Retirement Accounts You Should Know

However, when it comes to your 401(k) plan, there are primarily two options: Traditional 401(k) and Roth 401(k).

Traditional 401(k)

Traditional 401(k) contributions are made with pre-tax dollars, ultimately reducing your taxable income and allowing your contributions to grow tax-deferred until you withdraw your money in retirement.

Who Is It Good For?

Traditional 401(k)s can potentially be more beneficial if you think you will be in a lower marginal tax bracket when you start withdrawing funds in retirement.

Roth 401(k)

In contrast, Roth 401(k) contributions are made with after-tax dollars. This option gives you tax-free growth and — as long as you follow the rules — fully tax-free withdrawals once you reach 59½ and if the account has been in place for at least 5 years.

Roth 401(k) users can contribute up to $20,500 in 2022, and individuals aged 50 and over can contribute up to an additional $6,500, just like with traditional 401(k) options.

If you have a Roth 401(k) and plan to withdraw from your account prior to turning 59½, you may be subject to a 10% withdrawal penalty on a portion of the withdrawn amount.

Unlike with a Roth IRA, RMDs are mandated with a Roth 401(k) starting at age 72.

Who Is It Good For?

Roth 401(k)s are typically good for people who think they will be in a higher tax bracket in the future because of the tax-free withdrawals in retirement. What’s more, you can avoid RMDs by rolling the plan into a Roth IRA upon reaching age 59½ or leaving your employer. For these reasons, Roth IRAs can be an effective legacy planning tool.

401(k) FAQs

Here are a few common questions about 401(k)s.

Should I Invest in a 401(k) Even if I Have an IRA?

Even if you have an IRA, investing in your 401(k) could be a smart move for your nest egg. Both workplace 401(k) plans and individual retirement accounts represent important building blocks in your retirement savings. Supplementing your workplace retirement account is a great way to boost your retirement savings and put even more of your money to work in tax-advantaged accounts.

How Much Should I Contribute to My 401(k)?

This is an important question, and the answer varies based on each individual’s personal financial circumstances. In 2022 the contribution limit for a 401(k) is $20,500. If you are over the age of 50, then you can contribute up to an additional $6,500 per year. It’s important to note that employer matching contributions don’t count toward this limit, but there is a limit for employee and employer contributions combined: Either 100% of your salary or $57,000 ($63,500 if you’re over 50), whichever is greater.

Should I Max Out My 401(k)?

Generally, the more you can contribute, the better. However, situations arise where you may need to prioritize your cash savings in your emergency fund or save for a different reason, such as for a home down payment or a new car. If your employer offers matching, try contributing at least the required amount in order to take full advantage of the match.

What Happens if the Market Crashes?

Facing market volatility can be scary, but it is all part of the normal economic cycle. In 2020 we experienced a major market dip, and many people felt inclined to either pull the money out of their 401(k) or stop contributing to the plan. If you are fortunate to have stability during economic hardships, there are certainly ways for you to optimize your 401(k) without having to make drastic changes. If you have a long-term plan and are still able to contribute to your retirement, we typically encourage you to still do so, as down markets often represent good buying opportunities through dollar-cost averaging. Your 401(k) will be in good shape to take advantage of the recovering markets if you periodically rebalance your portfolio.

Next Steps for You

Now that you know your 401(k) better, here are a few next steps to get yourself on track to a happy retirement.

Download 65 Ways to Retire Smart, an actionable guide with insights from fiduciary financial advisors. The guide is free.
Sign up for the Personal Capital Dashboard. Millions of people use these free and secure professional-grade online financial tools. You can use them to see all of your accounts in one place, analyze your spending, and plan for long-term financial goals.
Consider talking to a fiduciary financial advisor for more detailed guidance on your retirement saving strategies.

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