What Is a 401(k) Plan and How Do They Work?
401(k) Plans Are a Great Way to Save for Retirement
Many employers offer a 401(k) retirement plan to employees as part of their benefits package. 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), your employer must follow certain rules. 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.
The following are the basic rules around tax benefits, employer contributions, and investment choices that impact how a 401(k) plan works.
Defining a 401(k) Retirement Plan
A 401(k) retirement plan is a special type of account funded through pre-tax payroll deductions. The funds in the account can be invested in a number of different stocks, bonds, mutual funds, or other assets, and are not taxed on any capital gains, dividends, or interest until they are withdrawn. The retirement savings vehicle was created by Congress in 1981 and gets its name from the section of the Internal Revenue Code that describes it: section 401(k).
Tax Benefits and Pre-Tax 401(k) Contributions
Employers started offering 401(k) plans around 1978. While the main gist is that you put money into the plan pre-tax, it helps to understand how these contributions work.
Normally, when you earn money as an employee, you have income taxes withheld on the money 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 have chosen 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 only on the amounts you withdraw at that time. You'll pay a 10% 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).
What is the maximum contribution limit on your 401(k) account? The answer depends on your plan, your salary, and government guidelines. In short, your annual employee elective salary deferral limit is set by the Internal Revenue Service. The following lists maximum contribution limits:
- 2014: $17,500
- 2015: $18,000
- 2016: $18,000
- 2017: $18,000
- 2018: $18,500
- 2019: $19,000
- 2020: $19,500
Since 2006, the total maximum contribution limit has been increased periodically based on changes in the cost of living (inflation) in $500 increments.
If you are 50 years old or older and your employer offers “catch-up” contribution for your 401(k), you are eligible to contribute additional amounts up to the maximum contribution limits as follows:
- 2014: $5,500
- 2015: $6,000
- 2016: $6,000
- 2017: $6,000
- 2018: $6,000
- 2019: $6,000
- 2020: $6,500
Since 2006, the maximum catch up contribution limit has been increased based on changes in the cost of living, in increments of $500.
Tax Savings Example
The following example will show you how the tax savings works. Assume you make $50,000 a year and decide to contribute 5% of your pay, or $2,500 a year, to your 401(k) plan. If you get paid twice a month, then you'll have $104.17 taken out of each paycheck before taxes have been applied, and put into your 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% 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 Traditional Roth 401(k) contributions. With Roth contributions, which were allowed starting in 2006, you don't get to reduce your earned income by the contribution amount, but all funds grow tax-free, and when you take withdrawals in retirement, you get to take all of your withdrawals tax-free.
Pre-Tax or After-Tax?
As a general rule of thumb, you want to make pre-tax contributions to your account during the years where you earn the most, which usually occurs in the middle and late stages of your career. Make your Roth contributions during years where your earnings and applicable tax rate are not as high since you'll use after-tax dollars. 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% of your pay, then 50 cents on the dollar up to the next 2% of your pay.
In our example above, if you were contributing 5% of your $50,000 salary, or $2,500 a year, your employer would be contributing $2,000. They would match the first 3% of your pay, or $1,500, by putting in $1,500. On the next 2% 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.
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% 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% vested you will only keep a portion of what the company put in for you. You always get to keep any of the 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 that 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, you will be best off using a target-date fund or model portfolio option. These default options are essentially foolproof ways to invest.
Other Rules to Follow
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.
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