What Is a 401(k) Plan and How Do They Work?
401(k) Plans Are a Great Way to Save for Retirement
A 401(k) plan is a type of retirement plan that your employer can legally offer to employees. The plan allows both the employee and employer to get a tax deduction when they put money into the employee's 401(k) retirement account.
To offer a 401(k), there are many rules that your employer must follow. The Department of Labor (DOL) has a division called the Employee Benefits Security Administration that regulates the offering of 401(k) plans and spells out these rules.
Here are the basic rules around tax benefits, employer contributions, and investment choices that impact how a 401(k) plan works.
When 401(k) plans started (about 1978), you put money into the plan pre-tax. We’ll look at how pre-tax contributions work first.
Pre-Tax 401(k) Contributions
Normally, when you earn money, you must pay income taxes on what you earn. A 401(k) plan allows you to avoid paying income taxes in the current year on the amount of money (up to the legal allowable 401(k) contribution limit) that you put into the plan. The amount you put in is called a salary deferral contribution, as you are choosing to defer some of the salary you earn today, put it in the plan, and save it so you can spend it in your retirement years.
The money grows tax-deferred inside the plan. Tax-deferred means as the investments earn investment income you do not pay tax on the investment gains each year.
Instead, in retirement, you pay tax on the amounts you withdraw at that time. There is a 10 percent penalty tax and income taxes if you withdraw funds too early (before age 55 or 59 ½ depending on your retirement age and 401(k) plan rules).
Tax Savings Example
Let’s look at an example to see how the tax savings works.
Assume you make $50,000 a year and decide to contribute 5 percent of your pay, or $2,500 a year, to your 401(k) plan. If you are paid twice a month, then $104.17 is taken out of each paycheck and put into the 401(k) plan.
At the end of the year, the earned income you report on your tax return will be $47,500 instead of $50,000 because you get to reduce your reported earned income by the amount you put pre-tax into the 401(k) plan.
If you are in the 25 percent marginal tax rate, the $2,500 you put into the plan means $625 less in federal taxes paid. You save $2,500 for retirement, but it only costs you $1,875.
The example above assumes you choose the traditional pre-tax 401(k) contributions, where you contribute money on a pre-tax basis.
Roth 401(k) Contributions (After-Tax)
Many employers also offer the option to put in Designated Roth 401(k) contributions. With Roth contributions (which began to be allowed in 2006), you do not get to reduce your earned income by the contribution amount, but all funds grow tax-free, and when you take withdrawals in retirement, withdrawals are tax-free!
Pre-Tax or After-Tax?
As a general rule of thumb, you want to make pre-tax contributions during the years where you earn the most, which usually occur in the middle and late stages of your career.
You want to make Roth contributions during years where your earnings (and thus tax rate) are not as high. Lower earning years often occur during the early stages of a career, during years of half-employment, or during a phased retirement where you work part-time.
Many employers will make contributions to your 401(k) plan for you. There are three main types of employer contributions: matching, non-elective, and profit sharing. Employer contributions are always pre-tax, which means when they are withdrawn in retirement, they will be taxable at that time.
With a matching contribution, your employer only puts money into the 401(k) plan if you are putting money in. For example, they may match your contributions dollar-for-dollar up to the first 3 percent of your pay, then 50 cents on the dollar up to the next 2 percent of your pay.
In our example above, if you were contributing 5 percent of your $50,000 salary, or $2,500 a year, your employer would be contributing $2,000. They would match the first 3 percent of your pay, or $1,500, by putting in $1,500. On the next 2 percent of your pay, $1,000, they would be matching 50 cents, or $500. Thus, the total they would contribute on your behalf would be $2,000 for the year.
If your employer offers a matching contribution, it almost always makes sense to contribute enough money to receive the match. Think of it as an instant raise!
With a non-elective contribution, your employer may decide to put a set percentage into the plan for everyone, regardless of whether the employee is contributing any of their own money or not. For example, an employer may contribute 3 percent of pay to the plan each year for all eligible employees.
With a profit-sharing contribution, if the company makes a profit, they may elect to put in a set dollar amount to the plan. There are different formulas that determine how much can go to who. The most common formula is everyone receives a profit sharing contribution that is proportional to their pay.
When Is the Money Yours?
Some types of employer matching contributions are subject to a vesting schedule, which means although the money is in your account, if you leave before you are 100 percent vested you will only keep a portion of what the company put in for you. You always get to keep any of your funds that you contributed to the plan.
Employers cannot set up 401(k) plans just to benefit owners or highly compensated employees. Each plan must go through an annual test to make sure it meets these rules, or the employer can set up a special type of plan called a “Safe Harbor 401(k) Plan” which allows them to bypass the cumbersome testing process.
With a Safe Harbor plan, as long as the employer is putting in a legally required amount, either as a match or non-elective contribution, then their plan will “pass” any of the tests. With a Safe Harbor plan, any matching or nonelective contributions the employer puts in for you are immediately vested! (Profit sharing contributions may still be subject to a vesting schedule.)
Most 401(k) plans will offer a minimum of three different investment options that have very different risk levels and participants must receive education on their choices. Government rules also restrict the amount of employer stock or other types of investments that can be used in a 401(k) plan. Due to these restrictions, the most common types of investments offered in 401(k) plans are mutual funds.
Many plans will set up a default investment choice (a specific mutual fund), and all money goes there until you log in online or call your plan to change to a different investment.
401(k) Investment Choices for Beginners
Most 401(k) plans offer target-date funds which have a calendar year in the name of the fund that is intended to match the approximate year where you think you may retire. These can be a great choice for new investors.
Some 401(k) plans also offer model portfolios, where you fill out a questionnaire, and then a selection of investments is recommended for you. Unless you are a sophisticated investor or working with a financial planner who is making recommendations for you, most of you will be best off using a target date fund or model portfolio option. I call these default options foolproof ways to invest!
There are many additional rules that a 401(k) plan must follow to determine who is eligible, when money can be paid out of the plan, whether loans can be allowed, the timing of when money must go into the plan, and much, much more. If you’re into reading regulations, you can find a wealth of information in the Retirement Plans FAQ page of the Department of Labor website.