A 401(k) plan is a program offered by your employer, often as part of a larger benefits package, with the goal of helping you save for retirement. There are many reasons to use a 401(k) as a savings tool. Perhaps the biggest reason is that it that allows you to divert some of your earnings to a special account, which avoids having it get taxed like the rest of your income. Another is that many employers offer a matching program, in which they also deposit money into your account to match the money you put in, up to a certain amount. These features alone will help your savings grow at a faster rate than if you were to use a standard savings account.
There are several different types of 401(k) plans, each with unique pros and cons, including the traditional 401(k), a self-directed plan, a safe-harbor plan, a SIMPLE 401(k), a Roth 401(k), and a tiered profit-sharing plan structure.
Here we will cover some of the basic features of 401(k) plans, along with details of some of the more common types, so you can make an informed choice about whether the 401(k) might be the right tool to help you save for retirement.
If you work for a government agency or for a non-profit, you will not be eligible for a 401(k) account for that income. Instead, you might have something known as a "403(b) plan."
How Does the Standard 401(k) Plan Work?
It is important to note that 401(k) plans are designed to build wealth over time, but they are not investments in the standards sense. When you opt into a 401(k) plan, you set a dollar limit or a percentage of your pay to contribute to your account each pay period. (The IRS has rules about how much you can contribute, and these may vary from one year to the next; your workplace can provide all of the crucial details about your plan.) This is why you might also hear it called a "defined contribution" plan. Your employer has chosen a plan provider that builds wealth by using the funds to invest in any number of assets, such as mutual funds, stocks, index funds, and real estate investment trusts (REITs). In some cases, you may be able to choose how your funds are invested, or at least how safe you'd like the account managers to be with your money.
The money that you add to your 401(k) account each pay period comes directly out of your paycheck (before taxes), so you don't even need to think adding it. If your job offers a match program, you may be putting away more than you even put in.
The perks are clear, but there are downsides as well. 401(k) plans are designed to work over the long term, and is not advisable to take money out of your account, or else you may incur fees for early withdrawal. Moreover, those those taxes that you didn't have to pay when you put the money into your account will show up later, as you will be taxed on withdrawals.
The Roth 401(k)
One of the newest versions of these plans is the Roth 401(k). This special type of 401(k) has many of the same benefits of a Roth IRA. The money you add to the plan comes from after-tax dollars, meaning from income that has already been taxed on your paycheck. Contributions to Roth 410(k) plans count in your gross income each year, so when you add money to your plan, you do not get to write it off of your taxes. But you'll never pay a penny in income tax or capital gains tax on the money—even if it grows to tens of millions of dollars—by the time you retire.
By contrast, in a standard 401(k), contributions are tax-deductible, and you only pay taxes when the money is withdrawn.
The Small Business 401(k)
For small business owners or those who work for themselves, one great choice might be a self-employed 401(k), also known as a "solo 401(k)." This is a rather new type of retirement account. It has many features that may make it more attractive to small business owners than the more popular simplified employee pension individual retirement account (SEP-IRA).
Owners make contributions with pre-tax dollars, which are allowed to grow tax-free until they are withdrawn during retirement. As with all 401(k) plans, the IRS has limits on the amount a self-employed person can contribute to the plan.
Many people qualify for a solo 401(k) without even knowing it. If you work for yourself and have no employees, this type of plan might help you reach your retirement goals sooner, with its larger contribution limits and wider range of qualifying investments.
When you choose the assets to invest in through a 401(k) account, there are many risks you want to try to reduce. Most 401(k) accounts give you a degree of control over how much you invest, how you may choose to use these funds, and when you can or must withdraw. There are risks that come with certain actions, so it's important to know how they will affect your long-term savings goal.
Should You Invest in Your Company Stock?
No one can answer this for sure, but it's worth thinking about before acting blindly. Your employer may offer you a better deal on stock options than it would to the public at large, and that potential is worked into many 401(k) plans. Of course, if you have esteem for your employer, buying its stock is a good way to support it. But it's worth asking: How do you know whether your employer is a McDonald's or a Wal-Mart and not an Enron or a Worldcom? The first two made their employees very wealthy, whereas the last two suffered from absolute wipeouts.
Should You Max Out Your Contribution?
There is a risk of putting too much money into your 401(k) account at any one time. For one, make sure your budget can take it. If this type of account is new to you, it can be easy to get swayed by changes you see in your earnings, whether on your paycheck or in your 401(k). Most investments gain over time, so it's wise to start slowly and steadily.
Should You Take Money Out of Your Account?
If times are tough, and you're struggling to make ends meet, it may be tempting to withdraw funds from your 401(k) account. Not every account allows it, and those that do have strict rules. For one, your contributions will likely pause. You may incur fees, and you may be subject to harsh repayment plans. Even though it's your money, taking it out early is actually more like a loan than a withdrawal in the normal sense. Of course, there are times when using the funds in your 401(k) account is the best option you have. Just be sure you know the risks.
Should You Adjust Your Contribution?
Many people wonder whether you should stop adding money to your 401(k) account when the market is down, or when their job is in danger, or for any number of reasons. The logic seems sound, but in fact a 401(k) account is one of the safest places your money can be. Pausing contributions to your 401(k) can be a costly mistake.
What Happens to Your 401(k) When You Leave Your Job?
You have a choice to make about your 401(k) when you leave a job. If you close the account and withdraw the funds, you will be subject to taxes. The best option is often to "roll it over." The Rollover IRA is a special account that allows you to take the money in your 401(k) and protect it from taxes.
- The Roth 401(k) uses after-tax dollars, which grow tax-free.
- Self-employed 401(k) plans, also known as "solo 401(k)s," are for small business owners, independent contractors, and similar individuals.
- If you leave a job and have to take your money out of your 401(k), you can avoid penalty taxes by moving the money into a rollover IRA.
The Balance does not provide tax, investment, or financial services or advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Investing involves risk, including the possible loss of principal.