Many companies offer 401(k) plans to employees as part of their benefits packages. These plans allow both the worker and the employer to claim tax deductions when they put money into the retirement account.
Your employer must follow certain rules to be able to offer a 401(k). The Employee Benefits Security Administration, part of the U.S. Department of Labor, regulates these plans and spells out the rules.
What Is a 401(k) Plan?
A 401(k) plan is a special type of account funded through payroll deductions that are made before taxes are paid on the balance. The funds in the account can be put into various investments, usually mutual funds containing stocks or bonds. They're not taxed on any capital gains, dividends, or interest until the earnings are withdrawn.
Tax Benefits and Pre-Tax Contributions
Employers first began offering 401(k) plans when Congress passed the Revenue Act of 1978. You normally have income taxes withheld from the money you earn as a worker. A 401(k) plan allows you to 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 amount you put in is called a "salary deferral contribution," because you've chosen to defer some of the salary you earn today to put it into the plan. You can save this money so you can spend it in your retirement years. The money grows tax-deferred inside the plan.
"Tax-deferred" means that you don't have to pay tax on gains until you take money out of the plan.
You only pay tax on the amounts when you withdraw the money in retirement. You'll pay a 10% penalty tax and income taxes if you withdraw funds too early, before age 55 or 59 1/2. The age limit depends on your 401(k) plan's rules.
The most you can invest in your 401(k) account depends on your plan, your salary, and government guidelines. Your annual salary-deferral limit is set by the IRS. This limit is $19,500 in 2021 and $20,500 in 2022.
The contribution limit goes up periodically in $500 increments based on changes in the cost of living.
You can contribute additional amounts if you're age 50 or older if your employer offers these “catch-up” contributions. These limits are an additional $6,500 in 2021 and 2022.
A Tax Savings Example
Assume you make $50,000 per year. You decide to put 5% of your pay, or $2,500 a year, into your 401(k) plan. You'll have $104.17 taken out of each paycheck before taxes have been applied if you get paid twice a month. This money goes into your plan.
The earned income you report on your tax return at the end of the year will be $47,500 instead of $50,000 because you get to reduce your earned income by the amount you put into your plan. The $2,500 you put into the plan means $625 less in federal taxes paid if you're in the 25% tax bracket. Saving $2,500 for retirement, therefore, only costs you $1,875.
Roth 401(k) Contributions
Many employers also offer Roth 401(k) plans. You don't get to reduce your earned income by your contribution amount with these plans, but all funds grow tax-free. You can also take all of your withdrawals tax-free.
Pre-Tax or After-Tax?
It's often best to make pre-tax contributions to your plan in the years when you earn the most. This might be the middle and late stages of your career. Make your Roth contributions using after-tax dollars during years when your earnings and tax rate aren't as high. These years often occur during the early stages of a career or during a phased retirement when 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, so these will be taxed when you take the money out.
Your employer only puts money into the plan if you do so. It may match your contributions dollar for dollar, up to the first 3% of your pay, then 50 cents on the dollar, up to the next 2% of your pay.
Your employer would add $2,000 if you paid in 5% of your $50,000 salary, or $2,500 a year. It would match the first 3% of your pay, or $1,500, by putting in $1,500. It would match 50 cents, or $500, on the next 2% of your pay, or $1,000. Its total contribution on your behalf would then be $2,000 for the year.
It almost always makes sense to contribute enough money to receive the match if your employer offers one.
Your employer may decide to put a set percentage into the plan for all workers, regardless of whether you're putting in any of their own money. An employer can contribute 3% of pay to the plan each year for all eligible employees.
The company may elect to put a set dollar amount into the plan if it makes a profit. Different formulas determine how much can go to which workers. The most common formula is that all workers receive an amount proportional to their pay.
When Is the Money Yours?
Some types of matching employer contributions are subject to a vesting schedule. The money is there in your account, but you'll only get to keep a portion of what the company put in for you if you leave your job before you're 100% vested. You always get to keep any of the money that you personally put into the plan.
Employers can't set up 401(k) plans just to benefit themselves or their highly paid employees. A plan must go through a test each year to make sure it meets these rules, or the employer can set up a special plan called a “safe harbor 401(k) plan," which allows them to bypass the testing process. Its 401(k) plan will “pass” any of the tests as long as it puts in a legally required amount, either as a match or as a non-elective contribution. Any matching or non-elective contributions the employer puts in for you are vested right away with a safe harbor plan.
Profit-sharing contributions may still be subject to vesting schedules.
Most 401(k) plans offer at least three investment options. They have very different risk levels. You must receive education about your options. Government rules also restrict the amount of employer stock or other types of assets that can be used in a 401(k) plan.
The most common types of investments offered in 401(k) plans are mutual funds because of these rules.
Many plans set up a default option, such as a certain mutual fund. All money goes there unless and until you log in online or call your plan administrator to change it.
Options for Beginners
Most plans offer target-date funds based on a particular year in the future that matches the one when you think you may retire. These can be great options for new investors.
Some 401(k) plans also offer model portfolios. You'll fill out a questionnaire, and options then will be recommended to you. You might be best off using a target-date fund or a model portfolio unless you're a savvy investor or you're working with a financial planner to advise you. These default options are often foolproof ways to invest.
Other Rules to Follow
A 401(k) plan must follow several other rules to determine who is eligible, when money can be paid out of the plan, whether loans can be allowed, and when money must go into the plan. You can find a wealth of info on the Retirement Plans FAQ page of the U.S. Department of Labor website.
Frequently Asked Questions (FAQs)
How does a 401(k) work once you reach retirement?
If you're retired and have reached the minimum age required by your plan, then you're free to withdraw from your account penalty-free. The exact process will depend on the company that manages your 401(k), but you are free to sell investments and withdraw money in retirement as you please. Withdrawals from ordinary 401(k) plans will be taxed at your income tax rate. Roth 401(k) withdrawals are tax-free.
How does allocating work with a 401(k) plan?
Not all 401(k) plans give you the same amount of freedom to allocate funds as you wish. Some will allow you to rebalance your portfolio from a pre-selected list of investments. Others may give you even more freedom. There are also plans managed entirely by the 401(k) companies that don't give participants any say in allocation. Check with your human resources department to learn more about your options for adjusting your fund allocation.