What Is a 401(k) Plan? And How Do They Work?

Investing
Updated: 15th Jun 2021
Written by Parker Pope
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Investing
June 15, 2021
Written by Parker Pope

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If you are one of the lucky few who still have a pension to look forward to, you should absolutely feel lucky.

These plans are going extinct as fast as the dinosaurs, though the government and some large, older companies still offer pensions.

For those of you looking confused at the word “pension,” there was a time when many companies contributed to pension plans.

These were pools of money generated without contributions by the employee, and the payouts were usually enough for an employee to comfortably retire on.

Pensions are mostly a thing of the past, but the new plan that is offered by most employers as a retirement planning tool is the 401(k).

Let’s dive into the nitty-gritty about the 401(k) so you understand what it is and how you can benefit if your employer offers such a plan.

What Is a 401(k) Plan?

A 401(k) plan is a retirement account that is specifically offered by an employer as part of an employee’s benefits package.

As an over-simplification, the 401(k) is the spiritual successor to the pension, which was solely funded by employer contributions. The 401(k) allows both the employer and the employee to contribute.

As a retirement account, the 401(k) is not just a savings account. It can be invested just like a brokerage account in stocks, bonds, mutual funds, exchange traded funds, or other assets, though the offerings are limited by the investment firm that manages your employer’s 401(k) plan.

>> Learn More: Explore the best online stock brokers

How Do 401(k) Plans Work?

The specifics of a 401(k) account vary widely depending on the employer and how they structure their employee benefits package.

On the lower end, an employer may offer an employee the opportunity to open a 401(k) account, and the employee can benefit from the tax advantaged retirement contributions.

However, the employer may not contribute any money.

On the other hand, an employer can opt to contribute money to an employee’s 401(k).

It could be anything, but it’s somewhat standard for employers to contribute up to a certain amount of whatever the employee has opted to contribute.

We’ll get into more specifics shortly.

How Do 401(k) Contributions Work?

We mentioned tax advantages, and these are important to understand. The primary benefit of the 401(k) account is that all contributions are planned ahead, and your company’s payroll will automatically deposit them pre-tax.

This phrase was used on purpose because it’s thrown around all the time when discussing a 401(k). Pre-tax means that the money you contribute to your 401(k) is taken out before any federal income taxes, Medicare, or social security taxes are calculated and deducted from your paycheck.

This means that, when you contribute to a 401(k), you’re effectively lowering the amount of taxes you’re required to pay for a given year.

There are, of course, regulations that restrict your contributions, though the employers have their own restrictions surrounding contributions.

>> Learn More: What Is a Roth IRA? And How Do They Work?

Contributing to a 401(k)

Most employers will have the 401(k)-signup paperwork included in your sign-on package when you first begin your employment.

Sometimes there will be a wait time between your hire date and when contributions (either from you or your employer) may start.

Most plans are set up so that you can choose a percentage of your gross (pre-tax) income to contribute with each paycheck.

As an example, let’s say you make $60,000 a year on a bi-monthly basis, meaning you make $2,500 per paycheck.

If you opt for a 5% contribution, your employer payroll office will deposit $125 each paycheck without any effort on your part, and this will then be divided up among your investments however you’ve decided when the account was created.

What Are the Annual 401(k) Contribution Limits?

Of course, with great tax benefits comes great efforts to limit overuse. The US Department of Labor (DOL) regulates pension plans in the US, and they’ve announced that the 2021 contribution limit will be the same as it was in 2020.

This number is $19,500 for those under 50 years old and $26,000 for those over 50 years old.

Employer Matched 401(k) Contributions

In many cases, employers are still offering to contribute money towards an employee’s retirement savings as was done for pensions.

As mentioned previously, this is usually done in the form of matching the contribution amount that an employee makes at every paycheck up to a certain maximum.

The format for employer matched 401(k) contributions usually goes something like this: “<Employer> will match an employee’s 401(k) plan contributions up to a maximum of X% of that employee’s base compensation.”

Let’s go back to our contribution case above where you make $60,000 and contribute $125 every paycheck.

If your employer has a 401(k) plan that matches up to 5% of an employee’s base compensation, then your total contributions will be $250 at every paycheck.

If this seems like free money, that’s because it is! However, as with all good things, there is a catch…

Vesting and “Fully Vested”

“Vesting” has nothing to do with fashion. This is a word used to describe the amount of money you’re entitled to keep should you leave the company before reaching the “fully vested” status.

It should be noted that any contributions you make to your 401(k) are always fully vested, meaning you keep all the money you contribute.

In order to encourage employees to stay with the company, most, if not all, employers will have a system of limiting the amount of employer contributions you’re entitled to keep if you leave the company.

This system is usually based on the number of years with the company, and the percentage of contributions you’re entitled to keep increases when each tier is reached.

For instance, you may not be entitled to keep any contributions until at least 2 years with a company, then you’re entitled to keep 20%.

Becoming “fully vested” means that you reach the top tier – which could be anything from a year to 15 years or more – and are entitled to keep 100% of the employer contributions if you decide to leave the company.

Non-Elective Contributions

While the name sounds bad, this can actually be a great thing if your employer offers this.

“Non-elective contribution” means an employer contributes to a 401(k) even if an employee chooses not to contribute their own money.

It’s important to remember that, for any sort of employer contribution, the amounts are subject to change for any reason.

Profit-Sharing Contributions

An employer may elect to contribute to an employee’s retirement savings via a profit-sharing plan.

This means that an employer can elect to contribute a percentage of the company profits, or really any other metric, to an account, but the employee cannot contribute to a profit-sharing plan.

A 401(k) plan can also be set up in addition to a profit-sharing plan allowing the employee to contribute.

Can You Contribute to Both a Traditional and Roth 401(k)?

Some employers may offer both a traditional 401(k), which we’ve been talking about, as well as a Roth 401(k), which is a slightly different type of account.

A Roth 401(k) is funded by after-tax money, but any growth in the account (interest, dividends, etc.) is tax free upon withdrawal. We’ll get into taxes shortly.

If your employer offers both types of accounts, you can certainly contribute to both. You should know that both the traditional and Roth 401(k) have contribution limits.

401(K) Taxes Explained

First, the traditional 401(k). While the contributions are deposited pre-tax, you are taxed on any withdrawals you take out at your regular federal income tax rate.

Not only that, but traditional 401(k) accounts require owners to be at least 55 or 59 ½ (depending on the plan) before they are allowed to withdraw funds.

Of course, it’s not prohibited, but any money withdrawn early is subject to not only a 10% penalty but also federal income taxes.

The Roth 401(k) is taxes differently. Since you’ve already paid taxes on the money you’re contributing (after-tax), any money you withdraw upon your retirement, called a distribution, is tax free.

You can withdraw money without any penalty before age 59 ½, though the money must fall under a “qualified distribution.”

This means that the account must be at least five years old, the account holder experiences a disability, or the account holder reaches the age of 59 ½.

Pre-Tax or After-Tax?

Let’s summarize these terms so they’re clear.

Traditional 401(k) accounts are funded pre-tax. This means that the money you contribute is deducted before you pay federal income tax, Medicare, and social security tax.

While you don’t pay tax on contributions, you will be required to pay federal income taxes when you retire and start regular withdrawals.

Roth 401(k) accounts are funded after-tax. This means that money you contribute comes from your take-home pay after federal income, Medicare, and social security taxes and any other deductions are taken out.

Since you’ve paid taxes already, any distributions you take out after retirement are tax free, which means no federal income tax.

Generally speaking, if you expect your tax bracket to change drastically over the course of your career, a Roth 401(k) account may benefit you more.

Distributions coming from a traditional 401(k) account would be taxes at your regular tax bracket, so if it’s much higher when you retire, it could have dramatic effects on your income.

What 401(k) Investments Are Available?

The investment choices you make for your 401(k) contributions depend heavily on what investments are offered through your employer’s plan.

Options are limited drastically compared to what an investment firm offers regular brokerage clients, and this is simply done to manage risk.

After your plan’s options, investment choices depend on your tolerance for risk.

Whether you’re risk averse (don’t like taking risk) or you prefer more risk in your portfolio, the investment firm managing your employer’s 401(k) plan should be able to point you in the right direction.

>> Learn More: How to Invest for Retirement

How Do 401(K) Required Minimum Distributions (RMDs) Work?

Both types of 401(k) account include rules for required minimum distributions (RMD).

This means that, after age 72, owners are required to withdraw a certain percentage of their 401(k)-account balance.

The RMD was created in order to discourage retirees from using the 401(k) to avoid paying taxes. It might seem cruel, but with people working well into retirement, it could result in some accounts going completely un-taxed if the rule wasn’t in place.

The RMD is calculated by dividing the account balance as of Dec 31 the previous year by the distribution factor declared by the IRS.

This distribution factors are different depending on your age, but they can easily be found on the IRS website.

>> Learn More: How to Research and Pick Winning Stocks

What Happens to Your 401(k) When You Change Jobs?

  1. Roll Over Into an IRA: IRA stands for “Individual Retirement Account,” and the rules for these are very similar to 401(k) accounts. Generally, employees can roll into IRA accounts with no penalty, but be sure to strictly follow the rules provided by your brokerage as any missed steps can be costly.
  2. Leave It with Old Employer: Some employers will allow employees to keep their vested money in the company’s 401(k), though employee and employer contributions will no longer be possible.
  3. Transfer Plan to New Employer: this process is similar to rolling into an IRA but may be subject to the new employer’s 401(k) plan rules. Also, if the employee is nearly 72 years old, the money transferred to the new employer is not subject to RMD requirements.
  4. Withdraw Money: As discussed previously, early withdrawals from 401(k) plans could result in ludicrous taxes. If you really need the money for some reason, then be prepared for that 10% penalty on traditional 401(k) non-qualified withdrawals before the age of 59 ½, not to mention income taxes.

Frequently Asked Questions

Can you lose money in a 401(K)?

From time to time, yes, you can lose money in a 401(k). However, since you’re not timing the market or day trading, it’s worth not even watching the account and letting it grow like it’s meant to.

Does compound interest still work in a 401(k)?

Yes! This is the biggest reason you should just leave the account alone to grow. Once the dividends, interest, and price growth have a chance to improve your returns, compound interest will give you another powerful account for your retirement.

How much of my salary can I contribute to my 401(k)?

You can contribute up to $19,500 for 2021. It should also be mentioned that this isn’t retroactive.

Bottom Line: What Is a 401(K) Plan?

Even though the 401(k) plan has a wide range of applications, it still remains an excellent tool for not only retirement planning but also (temporary) tax deferment.

While the pension is mostly on the way out, the 401(k) is replacing it as a way to encourage employees to take hold of their retirement plan.

The 401(k) provide employees the opportunity to contribute either pre-tax or after-tax money and potentially capture benefits offered by employers in the form of free contributions.

Employers must understandably impose limits on any contributions they make, so employees would do well to carefully read the literature provided on their employers’ 401(k) plan.

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Parker Pope
Parker Pope
Parker has spent over 10 years studying the financial markets. He currently manages his own portfolios by trading options and futures, and he’s excited to share his experience with those interested in a hands-on approach to their investments. No fancy tricks or indicators, just a commitment to understanding risk management and knowing the “why.” While he invests actively, he’s built a wealth of knowledge about personal finance and commits his efforts to writing about topics to help people take control of their finances.