What Is a 401(k)?

A 401(k) is an employer-sponsored retirement savings plan that lets employees set aside a portion of their wages for the future. It also allows them to reap tax benefits in the process.

Learn how a 401(k) works and what it requires; then, determine whether it's the right retirement savings option for you.

What Is a 401(k)?

A 401(k) is a qualified retirement plan. It's typically a feature of a broader employer profit-sharing plan.

401(k)s are a type of defined contribution plan. This means 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.

These accounts also accept 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 subsection of the Internal Revenue Code that established 401(k) plans.

How Does a 401(k) Work?

A 401(k) is available in many workplaces as a benefit to employees. If your employer offers it, it's worth considering; 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. Others may have to wait until a certain length of time is over to enroll in the plan.

When you enroll, you can specify what fixed percentage or amount of each paycheck you want to set aside in your employee 401(k) account. You can also choose 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."

HR departments often take care of the management of the plan. If you're traditionally employed, your employer will deduct your contributions from your paycheck; then, they will funnel them into the investments you chose, in your desired asset allocation. You'll never even have to handle the money.

With a traditional 401(k), any contributions you make are excluded from your taxable income in the contribution year. In other words, they are eligible for a tax deduction that year. Also, contributions and earnings grow tax-deferred. This means you won't pay taxes until you take distributions from the account.

Note

Contributions you make to your 401(k) are also sometimes known as "elective salary deferrals."

In addition, some employers make matching contributions to your account. For instance, your employer might add $0.50 for every dollar you contribute to the plan, up to a certain amount.

Let's say 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. But he pays taxes and as if he only earned $75,000 that year; the $5,000 contribution is tax-deductible. That means it's 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 1/2, Jack decides to withdraw money from his 401(k). At this point, he pays taxes on it. His tax rate is based on his tax bracket at the time of withdrawal. In this case, it is lower than it was in his earning years.

Tip

Look into investing the tax savings you get from making pre-tax 401(k) contributions. This can help grow your portfolio faster.

Types of 401(k)s

There are two main types of 401(k) plans, each with unique tax implications.

Traditional 401(k)

Also known as a "pre-tax 401(k)," this type allows you to contribute before-tax dollars. Your contributions are tax-deductible; both contributions and earnings grow tax-deferred. But distributions of contributions or earnings are subject to federal and state income taxes.

Roth 401(k)

These are 401(k)s plans that allow for designated Roth contributions. They are 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 won't have to pay taxes again on qualified distributions from the account.

Note

A Roth 401(k) distribution is usually considered "qualified" in a few situations: 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 1/2.

For instance, suppose Sally works at the same place as Jack. She also earns $80,000. Sally then 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 taxes.

When Sally turns 59 1/2 and takes money out of her Roth 401(k), she won't have to pay any taxes on the distribution.

What Are the Requirements for a 401(k)?

Both types of 401(k)s may be made available to employees if their job offers them. But traditional 401(k)s are by far more common.

If you work for a business that offers a 401(k), there may be requirements, such as a waiting period before you can enroll. Or, there may be 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. Some plans also allow for immediate vesting of employer contributions. Once an employer's requirements have been met, you can enjoy the full benefits of the plan.

Remember that you can't keep money in a 401(k) forever. Starting at age 72 (age 70 1/2 if you were born before July 1, 1949), you'll have to start withdrawing what is known as a required minimum distribution (RMD). This 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 You Contribute to a 401(k)?

Both forms of 401(k)s have the same contribution limit: $19,500 for 2021 and $20,500 for 2022. The catch-up amount, which is for those aged 50 or older, allows these employees to contribute $6,500 more per year in 2021 and 2022.

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). But the rare 401(k) plan might state that you can no longer make elective salary deferrals once you reach the total annual compensation limit. This is $290,000 for 2021 (increasing to $305,000 in 2022), even if you haven't reached the yearly contribution limit.

Also, 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. This increases to $61,000 in 2022.

Tip

Once you have a 401(k), you won't lose the money invested in it when changing employers. Look into 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.
  • 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 1/2, it's known as an "early withdrawal." Early withdrawals from a 401(k) are usually subject to a penalty; it amounts to 10% of the withdrawal.

Likewise, if you take a distribution from a Roth 401(k) before reaching age 59 1/2, the earnings (but not the contribution) portion of the distribution must be included as taxable income. It may also be hit with the 10% early-withdrawal penalty.

401(k) vs. IRA

What if you want to save for retirement but don't have access to a 401(k) plan? You still have options. For instance, you could look into individual retirement accounts (IRAs) instead.

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; thus, they afford an upfront tax break that you will pay for at the time of distribution. This is like that of a traditional 401(k). 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 put as much money into an IRA as you can to a 401(k). The IRA contribution limit is $6,000 in tax years 2021 and 2022 ($7,000 for people aged 50 or older). This includes combined traditional and Roth IRA contributions.Also, there are no RMDs for Roth IRAs, though there are for traditional IRAs.

Finally, more income limitations apply to both traditional and Roth IRAs than to 401(k) plans. With Roth IRAs, you can only contribute a reduced amount. Or, if you earn more than a certain amount, none at all. Participation starts to phase out for single filers who earn at least $125,000 in 2021 (increasing to $129,000 for 2022). Also, you'll qualify for a limited (or no) tax deduction on a traditional IRA if you or your spouse are covered by a plan at work and your income exceeds certain levels. The phase-out starts at $66,000 for single filers in 2021. This increases to $68,000 in 2022.

401(k) IRA
Higher contribution limits Lower contribution limits
Required minimum distributions No RMDs for Roth IRAs
Income generally doesn't limit participation Income may limit your Roth IRA contributions and traditional IRA deductions

Key Takeaways

  • 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 give you for a tax break, but you usually won't pay taxes on distributions.
  • Plans may require a waiting period before enrollment and a vesting schedule to receive employer contributions; also, they often mandate that you take minimum distributions starting at age 72.
  • Employees can contribute a maximum of $19,500 to a 401(k) in 2021 (increasing to $20,500 in 2022).
  • An IRA is an alternative to a 401(k) that comes with lower contribution limits. But it also comes with more income restrictions.