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What is a 401(k) and How Do They Work?

Updated: April 16, 2021, 4:50 p.m.

A 401(k) is a tax-advantaged retirement account offered through an employer. Employees may elect to defer a certain percentage of their paychecks to their 401(k)s, and employers often match some of these contributions.

The various types of 401(k)s differ in eligibility requirements and how they are taxed. Here's everything you need to know if you're thinking about contributing to a 401(k).

Basics of 401(k) plans

401(k)s are company-sponsored retirement plans, so as soon as an employee meets the company's eligibility requirements, they may enroll and decide how much of each paycheck to contribute. Some companies automatically enroll employees in their 401(k) plans. Check with your company's HR department to learn more about your specific plan.

Placing your savings in a 401(k) confers many advantages. Here are some of the most important ones:

Tax savings

Traditional 401(k) contributions are tax-deferred. That means the account holder can deduct contributions in the year they’re made and only pay taxes on withdrawals as they occur. Additionally, there’s no tax when an account holder sells an investment for a gain, and there’s no tax on dividends received within a 401(k). With proper planning, you can save a lot of money in taxes.

High contribution limits

401(k) contribution limits are much higher than contribution limits for individual retirement accounts (IRAs). The ability to save more money in a tax-advantaged retirement account can help you reach your retirement goals faster.

Employer match

Employers often match a percentage of their employees' contributions, which is one of the biggest benefits of a 401(k). It’s like getting an immediate 50% or 100% return on your investment (depending on your company’s policy) just for saving for retirement.

Automatic contributions

One of the easiest ways to save for retirement is to do it automatically, and a 401(k) plan makes it as simple as possible. 401(k) contributions come straight out of an employee’s paycheck, and they’re typically designated as a percentage of wages. Some employers also offer the ability to automatically increase your contribution percentage each year to help employees save more.

Rollovers

When an employee leaves an employer, they have the option of rolling over their 401(k) into an IRA or their new employer’s 401(k). Doing so can expand the number of investment options available. But if your old employer has a really good plan, you also have the option of leaving your money there.

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401(k) investments

401(k) plans typically come with a limited set of investment options for participants. Here’s what you can typically find in a 401(k) plan:

Index funds

Index funds are mutual funds or exchange-traded funds (ETFs) designed to track the returns on a specified market index. Unlike actively managed funds, the fund manager’s sole purpose is to efficiently match the basket of securities found in the benchmark index. The index could be anything from U.S. large-cap stocks to emerging market stocks to U.S. Treasury bonds to alternative indexes tracking natural resources.

Target-date funds

A target-date fund is a fund of funds that bases its target allocation on a specified target retirement date. These funds are a popular choice among 401(k) account holders since they simplify the investment process to just picking a year to retire.

Actively managed mutual funds

Investors might find a smattering of actively managed funds in their 401(k) investment options. These funds are tasked with beating their benchmark index over the long term, but they often come with higher expense ratios to pay for the fund manager and research team behind the buy-and-sell decisions.

When can I withdraw from my 401(k)?

Here’s a closer look at some of the rules that apply to 401(k) withdrawals.

Distributions

You may take money out of your 401(k) at any time, but you will pay a 10% early withdrawal penalty if you do so before age 59 1/2 unless you have a qualifying exception. Qualifying exceptions include large medical expenses, educational expenses, and first-home purchases, among others.

Required minimum distributions

Required minimum distributions (RMDs) are mandatory distributions from 401(k)s that must begin when you turn 72. Before 2020, RMDs were required to begin at age 70 1/2. Calculate your RMD by dividing your 401(k) balance by the distribution period next to your age in this table. Failure to annually withdraw at least this much triggers a 50% penalty on the amount that you should have withdrawn.

Adults ages 72 and older who are still working may delay RMDs from their current 401(k) until they retire, although if they have any IRAs or old 401(k)s from former employers, they must still take RMDs from these accounts starting at age 72.

Rule of 55

The Rule of 55 permits those who quit their jobs or are fired in the year they turn 55 or later to take penalty-free withdrawals from their 401(k) even if they are younger than 59 1/2. Public safety workers are eligible for penalty-free distributions if they leave their jobs after they turn 50. You may take penalty-free distributions only from your most recent 401(k), not from other retirement accounts.

401(k) loan

Some 401(k)s enable participants to borrow money from their plans and pay it back over time with interest. For some people, a 401(k) loan can be a nice alternative to a traditional bank loan, but withdrawing funds could slow the growth of your retirement savings. If you are unable to pay back the full amount you borrowed by the end of the loan term, the outstanding balance is considered a distribution and taxed accordingly.

What are 401(k) limits?

These are some of the key 401(k) rules and limits you should be aware of if you plan to contribute to this type of account.

Contribution limits

You may contribute up to $19,500 to a 401(k) in 2020 and 2021, unless you are age 50 or older, in which case you may make an extra catch-up contribution of up to $6,500. These contribution limits can change yearly.

Income limits

People classified by the IRS as highly compensated employees (HCEs) -- those who own more than 5% of the company they work for or earn more than $130,000 annually in 2020 and 2021 -- may not be eligible to contribute to their 401(k)s up to the maximum limits. Those in the top 20% of their company by income may also be classified as HCEs if their company so chooses.

Employers must perform nondiscrimination tests annually to ensure that HCEs aren’t contributing significantly more money to their 401(k)s than non-HCEs. Long story short, average annual HCE contributions may not exceed non-HCE contributions by more than two percentage points. If they do, then HCEs are prohibited from contributing up to the annual limits outlined above.

Beneficiaries

If you’re married, you need your spouse’s written consent to designate someone other than your spouse as your 401(k) beneficiary. Otherwise, you may designate any person you like to inherit your 401(k) when you die, provided there are funds remaining in the account. If you fail to designate a beneficiary, the money usually goes to your estate.

Review your account’s beneficiaries at least annually. Divorce, birth or adoption of children, and deaths in the family can all necessitate a change in the existing beneficiaries.

Which type of 401(k) is best for you?

401(k)s come in several varieties. Most of the information above centers on tax-deferred 401(k)s, which are the most common. But other types of 401(k)s include:

  • Roth 401(k): This is much the same as a traditional 401(k) except contributions are made with after-tax dollars. Contributions to Roth 401(k)s don't reduce your taxable income for the current year but are distributed tax-free in retirement. Employers who offer matching programs cannot contribute directly to Roth 401(k)s and must instead contribute any matching funds to a traditional 401(k).
  • Solo 401(k): A solo 401(k) is available only to self-employed people. This type of 401(k) effectively has higher annual contribution limits because you can contribute as both employee and employer.
  • Inherited 401(k): An inherited 401(k) is what a beneficiary receives when the original 401(k) owner dies. After the account is transferred, the beneficiary may not contribute any new money to the account and must withdraw it within a set number of years. If the original owner of the 401(k) was the beneficiary’s spouse, then the beneficiary may roll it over into his or her own 401(k).

Other retirement plans that may be right for you

A 401(k) is just one type of retirement plan, but there are a lot of different accounts you can use to help you reach your retirement goals.

In addition to your 401(k) at work, you can also use an IRA. An IRA has similar tax treatment as a 401(k), and there are both traditional and Roth options.

One big advantage of an IRA versus a 401(k) is that investors have a lot more investment choices. Additionally, IRAs typically have no fees attached.

On the other hand, IRAs have income limits that restrict an investor’s ability to contribute or take a tax deduction for their contribution. Careful planning can ensure you get the biggest tax advantage possible for your situation.

401(k) vs. other retirement accounts

Here’s a closer look at how 401(k)s stack up against other common retirement accounts.

IRA

Anyone earning income can open an IRA and contribute up to $6,000 in 2020 and 2021 or $7,000 if they're age 50 or older. These contribution limits are lower than 401(k) limits, but IRAs give you more freedom to invest how you choose and may also have lower fees.

403(b)

A 403(b) plan is similar to a 401(k) but is available only to certain ministers, public school employees, and employees of tax-exempt organizations. Contribution limits are the same as for 401(k)s, with the exception that employees who work for the same company for at least 15 years may contribute up to $3,000 more per year.

457(b)

A 457(b) plan is a type of retirement account available only to state and local governments and some nonprofit employers. Standard contribution limits are the same as for 401(k) plans, but 457 plans, including 457(b)s, have higher catch-up contribution limits for those 50 and older. With 457(b) plans, there is no penalty for withdrawing funds before age 59 1/2.

401(a)

401(a) plans, like 457(b) plans, are commonly offered by governments, public schools, and nonprofit organizations. Participation in a 401(a) plan is often mandatory, and the employer determines how much of each employee's paycheck is placed into their 401(a) account. These plans are highly customizable, and the contribution limits are the same as those of 401(k)s.

Pension

Pension plans provide a guaranteed source of monthly income in retirement, while 401(k)s do not. Also, only employers fund pensions, while employers and employees (primarily employees) fund 401(k)s. Pensions are rare today; employers generally choose to offer 401(k)s in lieu of pensions.