A 401(k) is an employer-sponsored retirement savings plan that lets employees set aside a portion of their wages for the future and reap tax benefits in the process.
Learn how a 401(k) works and what it requires to determine if it's the right retirement savings option for you.
What Is a 401(k)?
A 401(k) is a qualified retirement plan that's typically a feature of a broader employer profit-sharing plan. It's a type of defined contribution plan, meaning that no set amount of benefits are promised at retirement. Instead, employees elect to contribute the desired portion of their wages for retirement to an individual account set up for each employee, which also accepts employer contributions. They're rewarded for these contributions with tax breaks that vary based on the plan type.
- Alternate definition: 401(k) is also the name of the subsection of the Internal Revenue Code that established 401(k) plans.
How a 401(k) Works
A 401(k) is available in many workplaces as a benefit to employees. If your employer offers it, it's worth considering as it's one of the easiest ways to start saving for retirement. Upon starting a new job, some employees are automatically enrolled in a 401(k) plan, whereas others may have to wait until their probation period is over to enroll in the plan and start contributing.
When you enroll, you'll specify not only what fixed percentage or amount of each paycheck you want to set aside in your employee 401(k) account but also which investments you want to put that money in and what portion of the money you want to go toward each investment. The spread of your money across different types of investments is known as your asset allocation.
Your HR department typically takes care of the management of the plan. If you're traditionally employed, your employer will deduct your contributions from your paycheck and funnel them into the investments you chose, in your desired asset allocation, without you ever handling the money.
With a traditional 401(k), any contributions you make (known as elective salary deferrals) are excluded from your taxable income in the contribution year—in other words, eligible for a tax deduction that year. Moreover, contributions and earnings on contributions grow tax-deferred, meaning you won't pay taxes until you take distributions from the account in retirement. In addition, some employers make matching contributions to your account. For example, your employer might contribute $0.50 for every dollar you contribute to the plan up to a certain amount.
For example, say that Jack makes $80,000 per year. He enrolls in his employer's 401(k) plan and chooses a variety of mutual funds. He contributes $5,000 to his 401(k) in a given year through paycheck deductions. However, he pays taxes and as if he only earned $75,000 that year, as the $5,000 contribution is tax-deductible and is thus excluded from his taxable income.
The money grows tax-deferred, so Jack doesn't pay taxes on the contributions or gains over time. At age 59.5, Jack decides to withdraw money from his 401(k), at which point he pays taxes on it. His tax rate is based on his tax bracket at the time of withdrawal, which is lower than his tax bracket was in his earning years.
Consider investing the tax savings you get from making pre-tax 401(k) contributions to help grow your portfolio faster.
Types of 401(k)s
There are two main types of 401(k) plans, each with unique tax implications.
Also known as a pre-tax 401(k), this type of 401(k) allows you to contribute before-tax dollars. Although your contributions are tax-deductible, and both contributions and earnings grow tax-deferred, distributions of contributions or earnings on those contributions are subject to federal (and if applicable, state) income taxes.
These are 401(k)s plans that allow for designated Roth contributions, which are contributions made with post-tax dollars into a separate Roth account. Roth contributions are included in your taxable income at tax time, but contributions and earnings grow tax-free. As you'll pay taxes on your income before contributing to your 401(k), you don't have to pay taxes again on qualified distributions of contributions or earnings.
A Roth 401(k) distribution is usually considered "qualified" if the account has been in place for at least five years and the distribution was made as a result of disability, on or after the death of the account holder, or after reaching the age of 59.5.
For example, assume Sally works at the same company as Jack and also earns $80,000. She puts $5,000 into a Roth 401(k). At tax time, she can't deduct that $5,000 from her income, so the contribution doesn't reduce her tax liability.
When Sally turns 59.5 and takes money out of her Roth 401(k) money, she doesn't have to pay any taxes on the distribution.
Requirements for a 401(k)
Both types of 401(k)s are generally made available to employees if their employer offers them, although the traditional 401(k) is by far the most common.
If you're employed by a business that offers a 401(k), there may be requirements such as a probationary period before you can enroll and vesting (required time in the company) before you're entitled to employer contributions (such as matching contributions). However, employee contributions are fully vested at the time they're made, and some plans similarly allow for immediate vesting of employer contributions. Once an employer's requirements have been met, employees can avail the full benefits of the plan.
Also, remember that you can't keep money in a 401(k) forever. Starting at age 72 (age 70.5 if you were born before July 1, 1949), you'll typically have to start withdrawing what is known as a "required minimum distribution," which amounts to your account balance at the end of the year before the calendar year divided by a specific period from the “Uniform Lifetime Table" in IRS Publication 590-B.
How Much Can I Contribute to a 401(k)?
Both forms of 401(k)s have the same contribution limit for 2021 and 2020—$19,500. Also increased is the catch-up amount for those aged 50 or older; these employees can contribute $6,500 a year more in 2021 and 2020.
Typically, there's no limit to the amount of income you can earn to participate in either a traditional 401(k) or Roth 401(k). However, the rare 401(k) plan might stipulate that you can no longer make elective salary deferrals once you reach the total annual compensation limit, which is $290,000 for 2021 (up from $285,000 for 2020), even if you haven't reached the annual contribution limit.
In addition, combined employee and employer contributions to a 401(k) must be the lesser of all of an employee’s compensation or $58,000 in 2021 (up from $57,000 in 2020).
Once you have a 401(k), you won't lose the money invested in it when changing employers. Consider these options to allow your money to follow you throughout your career:
- Leave the money in the 401(k) of a former employer
- Roll it into a new employer's 401(k) plan, if allowed
- Roll it into an IRA
- Cash out
Are There Any Penalties?
If you withdraw contributions or earnings from a traditional 401(k) before age 59.5, it's known as an early withdrawal. Early withdrawals from a 401(k) are usually subject to an additional penalty amounting to 10% of the withdrawal.
Similarly, if you take a distribution from a Roth 401(k) before reaching age 59.5, the earnings (but not the contribution) portion of the distribution must be included as taxable income and may also be hit with the 10% early-withdrawal penalty.
401(k) vs. IRA
Many employees' who want to save for retirement but don't have access to a 401(k) plan consider individual retirement accounts (IRAs) as an alternative.
IRAs are available from investment firms and discount brokerage companies alike. As in the case of 401(k) plans, there are traditional IRAs and Roth IRAs. Traditional IRAs are funded with pre-tax dollars and thus afford an upfront tax break similar to a traditional 401(k) that you will pay for at the time of distribution. Roth IRAs, in contrast, are funded with post-tax dollars, but you generally won't pay taxes on qualified distributions.
The key differences are that you can't contribute as much money to an IRA as you can a 401(k); the IRA contribution limit (including combined traditional and Roth IRA contributions) is $6,000 in 2021 and 2020 ($7,000 for people aged 50 or older).
Moreover, there are no required minimum distributions for Roth IRAs, though there are for traditional IRAs.
Finally, more income limitations apply to both traditional and Roth IRAs than 401(k) plans. With Roth IRAs, you can only contribute a reduced amount or none at all if you earn more than a certain amount. Participation starts to phase out for single filers who earn at least $125,000 in 2021 (up from $124,000 in 2020). Moreover, you'll qualify for a limited or no tax deduction on a traditional IRA if you or your spouse is covered by a retirement plan at work and your income exceeds certain levels. The phase-out starts at $66,000 for single filers in 2021 (up from $65,000 in 2020).
|Higher contribution limits||Lower contribution limits|
|Required minimum distributions||No required minimum distributions for Roth IRAs|
|Income generally doesn't limit participation||Income may limit your Roth IRA contributions and traditional IRA deductions|
- A 401(k) is a retirement savings plan that allows employees and employers to contribute.
- A traditional 401(k) grants an upfront tax break, but you'll have to pay taxes when you take distributions. Roth 401(k) contributions don't qualify you for a tax break, but you usually won't pay taxes on distributions.
- Plans may require a probation period before enrollment and a vesting schedule to receive employer contributions and generally mandate that you take minimum distributions starting at age 72.
- Employees can contribute a maximum of $19,500 to a 401(k) in 2021 and 2020.
- An IRA is an alternative to a 401(k) that comes with lower contribution limits but more income restrictions.