What Is a 401(k) and How Does It Work?

401k Savings Piggy Bank
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A 401(k) is a savings account that offers several tax advantages that you can receive as part of your employee benefits program. It allows you to save some of your pay toward retirement. Many employers provide matching funds, which can boost your savings more.

Read on to learn more about how you can save with a 401(k) retirement plan.

What Is a 401(k) Plan?

A 401(k) plan is a retirement account offered by employers. Employees can opt to have some of their earnings deducted from their paychecks and put into a 401(k).

These deductions are pretax, which means that they come out before taxes are deducted. Pretax deductions lower an employee’s taxable income, which means that you will pay less in taxes.

401(k) retirement plans also have benefits for employers, such as attracting employees. Additionally, employers can deduct contributions on their federal income taxes.

Here are a few more quick facts about 401(k)s:

  • Plan sponsors offer a variety of investment options, including stocks, bonds and mutual funds.
  • Employees decide which investments they want and allocate funds.
  • Employees don’t pay taxes on contributions or interest until withdrawal.
  • Employees can contribute to both a 401(k) and an individual retirement account in the same year.

Retire Comfortably

How Does a 401(k) Plan Work?

If your employer offers a 401(k) plan, it will tell you when you can enroll. You may be eligible to start right away, or you may be required to wait until you finish a probationary period.

When you enroll, you’ll be able to choose how much you want to contribute and how those funds are invested. There’s a limit to how much you can contribute, however. Also, some employers match funds, so keep that in mind when you decide how much to put in.

What Is the Max 401(k) Contribution?

In 2020, the most you can contribute to a traditional or safe harbor 401(k) is $19,500. The most you can contribute to a SIMPLE 401(k) is $13,500.

The maximum amount of compensation used to determine employer and employee contributions in 2020 is $285,000. This rule helps keep plans fair to all employees.

What Is a 401(k) Catch-Up Contribution?

In 2020, you can contribute more to a 401(k) once you reach age 50 or older. You can contribute $6,500 more to traditional and safe harbor 401(k) plans and $3,000 more to SIMPLE 401(k) plans.

What Is 401(k) Matching?

Many employers contribute to 401(k) funds by matching how much employees put in. For example, your employer might match your contributions for up to 5% of your income.

Your employer-matched funds might not be available immediately. You may have to work for a specific time frame for those funds to be yours permanently. That process is called “vesting.”

Good To Know

There are maximums to how much can be contributed to a 401(k) by both the employer and employee. In 2020, the maximum for overall contributions is the lesser of the employee’s annual compensation or $57,000.

What Are the Types of 401(k) Plans?

Employers can offer several types of 401(k) plans, including:

  • Traditional 401(k) Plans
    With traditional 401(k) plans, employers can make contributions to all participants, match employee contributions or both. They can use a vesting schedule, and they have to pass an IRS test to make sure they’re not favoring high earners.
  • Safe Harbor 401(k) Plans
    With these plans, employer contributions are vested right away. In other words, once your employer contributes funds, those funds are yours.
  • SIMPLE 401(k) Plans
    These are 401(k) plans for small businesses that don’t have to pass the IRS test for traditional 401(k) plans. Employer contributions are vested immediately.
  • Roth 401(k) Plans
    Roth 401(k) plans allow employees to contribute on an after-tax basis. With a Roth 401(k), you don’t have to worry about paying taxes on qualified distributions.

Retire Comfortably

What Are the Advantages of a 401(k) Plan?

401(k)s have advantages now and in the future. They include:

  • Lowering Your Current Taxes
    Let’s say you make $60,000 per year. You contribute $5,000 during the year to your 401(k). Instead of being taxed on $60,000, you’re taxed on $55,000, which lowers your tax liability. That might not sound like much, but every little bit helps at tax time.
  • Tax-Deferred Growth
    You don’t have to pay taxes on the interest you earn until you withdraw funds. That allows your money to grow faster because it stays in your account and earns interest.
  • Potential Employer Contributions
    Free money is always good. If you’re not sure how much to contribute to a 401(k), aim to put in the maximum your employer will match. For example, if your employer matches up to 3% of your income, contribute at least that much if you can.

What Are the Disadvantages of a 401(k) Plan?

No retirement vehicle is perfect. The main disadvantage is that you can lose money in a 401(k) if your investments lose their value.

With a 401(k), what to invest in is a big decision. You could put it all in stocks, but you could lose some of your 401(k) if the market crashes.

A financial loss might be OK if you have time to recover. Many 401(k)s have targeted funds designed to get more conservative as you get closer to retirement.

Your plan sponsor may have resources to help you decide how to invest. You can also contact a financial advisor for tailored advice.

Can You Withdraw Money From a 401(k) Plan?

When it comes to what age to withdraw 401(k) funds, age 59½ is the magic number. It serves as a cutoff for having to pay early withdrawal penalties. That doesn’t mean your funds aren’t accessible before then, though. Here’s what you need to know.

Withdrawals Before Age 59½

In general, if you make withdrawals before age 59½, you pay a 10% early withdrawal penalty plus income taxes. There are exceptions, though.

Many plans allow hardship distributions. You may need to prove that you’re experiencing a hardship, like high medical bills or foreclosure, but you can withdraw the funds without the early withdrawal penalty.

COVID-19 CARES Act Withdrawals

The Coronavirus Aid, Relief and Economic Security Act has provisions that allow employers to let employees withdraw funds without a tax penalty. Additionally, employees have three years to pay income taxes on the withdrawal rather than just one.

To qualify, you, a spouse or a dependent must have been diagnosed with COVID-19 or experienced a financial consequence of COVID-19. You can withdraw up to $100,000 per person through Dec. 30.

Withdrawals After Age 59½

Once you reach age 59½, you can withdraw funds without a penalty, but you can also wait. In general, however, you must start taking withdrawals once you reach age 70½. However, if your 70th birthday was July 1, 2019, or later, you can delay withdrawals until age 72.

These withdrawals are called required minimum distributions. The amount you have to take out is based on individual circumstances.

401(k) Loans

Your 401(k) plan may allow you to borrow against your vested balance. The loan must be repaid (typically within five years), and if you leave your employer, the entire loan balance is due.

If you can’t repay the loan, it becomes a distribution, and you will owe taxes and an early withdrawal penalty.

What Happens to Your 401(k) When You Leave Your Employer?

You don’t lose your 401(k) if you quit your job. You have a few options:

  • Leave It With Your Former Employer
    You may be able to leave your 401(k) alone. The disadvantage of this is that it’s one more place to look for funds when you get ready to retire. Generally, it’s best to roll it over into a new plan.
  • Roll Over the 401(k) to Your New Employer’s Plan
    You can move your funds from an old employer to a new one without any tax penalties.
  • Roll Over the 401(k) to an IRA
    You can also move your 401(k) into a traditional or Roth IRA. If you choose a Roth, you’ll need to pay taxes on what you move.
  • Cash It Out
    If you’re younger than age 59 ½, this usually isn’t the best idea since you may have to pay an early withdrawal penalty.

Alternatives to a 401(k) Plan

Are you looking for a place to put your money after you’ve maxed out your 401(k)? Or are you self-employed or working for an employer that doesn’t offer 401(k)s? If so, IRAs can be an excellent alternative.

Traditional IRAs

If you don’t have access to a 401(k), you can contribute up to $6,000 to a traditional IRA in 2020 — or $7,000 if you’re age 50 or older by the end of the year — and deduct your full contribution. If you do have a 401(k), you can still contribute up to the limit, but your deduction may be limited, depending on your income.

Roth IRAs

Roth IRAs aren’t tax deductible, and you must meet income limits to contribute to one. The upside to Roth IRAs is that by paying taxes now, you won’t have to worry about them when you retire. And like traditional IRAs, you can withdraw your contributions at any time — sometimes without penalty.

Is Having a 401(k) a Good Idea?

While you might have good intentions, it can be hard to save. What makes a 401(k) better than savings is that your contributions come out of your paycheck before you receive it. It’s a painless way to save.

A 401(k) also lowers your tax burden. Since the funds are taken out pretax, the more you put into your 401(k), the lower your taxable income is, which can add up to significant savings over the years.

As you age, it gets harder to continue to work. You want to be able to relax, travel and spend time with loved ones. Setting aside funds in your 401(k) helps make your retirement dreams a reality.

To get started with a 401(k), ask your human resources department how and when you can sign up. Find out whether your employer offers a match. If it does, aim to set aside enough to take full advantage of your employer’s matching funds.

Even if your employer doesn’t match funds, a 401(k) can help you grow your retirement savings and lower your taxes. So, for most employees, it is a good idea.

Our in-house research team and on-site financial experts work together to create content that’s accurate, impartial, and up to date. We fact-check every single statistic, quote and fact using trusted primary resources to make sure the information we provide is correct. You can learn more about GOBankingRates’ processes and standards in our editorial policy.

About the Author

Melinda Sineriz has a Bachelor of Arts in English from Miami University and a master’s degree from Bard. She worked in insurance for six years, educating clients on Medicare supplements, life insurance, long-term care and annuities. She enjoyed helping clients make good financial decisions during and after retirement.  She also worked in dental insurance, assisting clients with enrollment and understanding their benefits.

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