What Is a 401(k) Retirement Plan?
A 401k is one of the best retirement savings vehicles available
A 401(k) plan is a retirement savings vehicle that falls under the category of a "defined-contribution" retirement plan, as determined by the IRS. That means that the employer's contribution to the plan is predefined.
If your employer says that they will match 50% of your 401(k) contributions up to the first 6%, they are making a defined contribution. A 401(k) is available in many workplaces as a benefit to employees. It's one of the easiest ways you can start investing and saving for retirement.
There are two different types of 401(k)s, each designed to give you the choice of contributing before or after taxes are withheld from your pay. The traditional 401(k) does not tax your contributions, but taxes your withdrawals; a Roth 401(k) taxes your contributions but not your withdrawals.
How 401(k)s Work
Your HR department typically takes care of the management of the plan. Upon starting a new job, some employees are automatically enrolled in a 401(k) plan, while others may have to wait until their probation period is over to start contributing.
Your employer will deduct your contributions from your paycheck and withhold taxes as required by the plan you have chosen. Some employers make matching contributions, and your money stays in the plan accumulating interest.
For example, say Jack makes $50,000 per year. He puts $5,000 into his 401k. He pays taxes and claims deductions as if he only earned $45,000 that year.
Jack's money is invested in a variety of stocks and mutual funds. The money grows tax-deferred, so Jack doesn't pay taxes on any of the capital gains and dividends that his 401(k) investments earn over time.
By deferring those taxes, Jack is able to reinvest that money, which enables his portfolio to grow faster.
When Jack turns 65 and decides to withdraw money from his 401(k), he pays taxes at that time. His tax rate will be based on the tax bracket for his income and tax laws in place.
401(k) distributions (withdrawals) are considered normal income by the IRS, which is why they are taxed—unless they are exempt (such as with a Roth 401(k)).
Roth 401(k) vs. Traditional 401(k)
There's an exception to this, however. The Roth 401(k) Plan allows people to pay taxes on their earnings before contributing to their 401(k). Because you have already paid taxes on the income, you are not required to pay taxes on your distributions.
For example, assume Sally earns $50,000. She puts $5,000 into a Roth 401(k). At tax time, she pays taxes on the full $50,000 she earned, paying her tax bill with the money withheld from her paycheck over the course of the year.
Her investments then grow tax-free, while Jack's investments grow tax-deferred. When Sally turns 65 and withdraws her Roth 401(k) money, she doesn't need to pay any taxes on it; neither her capital gains nor her dividends are taxed.
The Roth 401(k)s interest and distributions are not taxed, while the traditional 401(k) is tax-deferred until distributions are made. The key difference is the tax bracket you are in when you pay these taxes.
Who Has Access to a 401(k)?
Both types of 401(k)s are generally made available to employees if their employer offers them. Some smaller businesses are not able to afford official retirement plans, so their employees are left to find one on their own.
If you are employed by a business that offers a 401(k), there may be requirements such as vesting (required time in the company) before you can receive benefits. Once an employer's requirements are met, employees are able to elect a plan and begin contributing.
Once you have a 401(k), you do not lose the money invested in it when changing employers. You have options that allow your money to follow you throughout your career. You are able to:
- Leave the money with a former employer
- Roll it into an IRA
- Roll it into a new employer's 401(k) plan, if allowed
- Cash out
Considerations Before Signing Up for a 401(k)
Both forms of 401(k)s have the same contribution limit for 2020—$19,500. This is a $500 dollar increase from 2019, which generally occurs every year. Also increased is the catch-up amount for those that are age 50 or older—these employees are able to contribute $6,500 a year more in 2020.
With either option, it's worth finding out the specific benefits offered by your employer, as not all 401(k) plans are made equal. Some workplaces offer only traditional 401(k) plans, but not Roth 401(k) plans.
There is a compensation limit for contributing to a 401(k). You are able to contribute to one of these plans, with employer matching, up to the maximum contribution limit; once your total compensation for the year equals $285,000 for 2020 ($280,000 for 2019) you can no longer contribute. In this case, employers can only match up to the compensation limit.
If your workplace does not offer a Roth 401(k), but you're interested in having one, you can check to see if you're eligible to set up a Roth IRA instead. This will give you a similar tax-advantaged treatment, although you typically can't contribute as much money to an IRA as you can a 401(k).
At the very least, find out if a 401(k) is available. The earlier you start contributing, the more you'll have when you start making withdrawals.
U.S. Securities and Exchange Commission, Investor.gov. "Traditional and Roth 401(k) Plans." Accessed Feb. 16, 2020.
Finra.org." 401(k) Rollovers." Accessed Feb. 16, 2020.
Internal Revenue Service. "Retirement Topics - Catch-Up Contributions." Accessed Feb. 16, 2020.
Internal Revenue Service. "401(k) Plans—Deferrals and Matching When Compensation Exceeds the Annual Limit." Accessed Feb. 16, 2020.