What Is a 401(k) Plan? Everything You Need To Know

10 min Read

Marvin Samuel Tolentino Pineda / Getty Images/iStockphoto

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 for all the details 401(k)s and 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 of the paycheck before taxes are deducted. Pretax deductions lower an employee’s taxable income, which means that you will pay less in taxes that year.

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 how 401(k)s work:

Are You Retirement Ready?

How Does a 401(k) 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 2022, the most you can contribute to a traditional or safe harbor 401(k) is $20,500. The most you can contribute to a SIMPLE 401(k) is $14,000.

The maximum amount of compensation used to determine employer and employee contributions in 2022 is $305,000. This rule helps keep plans fair to all employees.

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

In 2022, 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.

Are You Retirement Ready?

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 2022, the maximum for overall contributions is the lesser of the employee’s annual compensation or $61,000.

What Are the Types of 401(k) Plans?

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

Are You Retirement Ready?

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. However, you will pay taxes on your contributions when you withdraw that money from the account in the future.

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.

Are You Retirement Ready?

A financial loss might be okay 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 allowed 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.

Are You Retirement Ready?

To qualify, you, a spouse or a dependent must have been diagnosed with COVID-19 or experienced a financial consequence of COVID-19. You could withdraw up to $100,000 per person during the 2020 calendar year.

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.

Are You Retirement Ready?

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 2022 — 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 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.

More From GOBankingRates

Cynthia Bowman contributed to the reporting for this article.

This article has been updated with additional reporting since its original publication.