What is a 401(k) and how does it work?

A 401(k) is a retirement savings plan that some employers offer. Contributing to a 401(k) comes with tax benefits because you only pay income taxes when you withdraw money.

Derek Silva

Derek Silva

Published November 7, 2019

info
Advertising Disclosure

KEY TAKEAWAYS

  • A 401(k) is a retirement savings plan you invest in through your employer.

  • Contributions are pre-tax income. You only pay income taxes when you withdraw money.

  • The contribution limit for 2019 is $19,000.

In the past, many workers received a pension and didn’t need to worry as much about saving for retirement. Pensions aren’t very common anymore and employers help their employees save through 401(k) plans.

A 401(k) is a retirement savings plan that some employers offer as a benefit to their employees. Starting in 1980 thanks to a tax loophole, 401(k) plans have since become commonplace. Employers don’t have to offer a 401(k), or any other retirement plan for that matter, but it’s a popular way to attract and retain employees. As of 2019, the maximum amount you can contribute to a 401(k) plan is $19,000 per year, which will go up to $19,500 in 2020.

With a 401(k) plan, you can defer and invest some of your earnings from each paycheck without paying any income taxes until you withdraw your money in retirement. A 401(k) is considered tax-advantaged because you can avoid or defer paying most taxes on your contributions.

You may also see the term “defined contribution plan.” This refers to the fact that you contribute a defined amount (e.g. 5% of your salary) but the amount you can withdraw when you retire varies. This differs from pensions—a type of “defined benefit plan”—which guarantee you a defined payout (benefit) when you retire.

In this article:

How 401(k) plans work: an overview

If your employer offers a 401(k), you have the option to defer some of the income from your paycheck and put it into a 401(k) account. This is pre-tax income, which means you don’t have to pay income tax on it. You only pay tax when you withdraw the money in the future. Since your income will probably be lower when you retire than it is at the peak of your career, you end up paying less in taxes overall.

When you put the money into your 401(k), you can choose from a number of different investment and savings options. Employers usually hire someone to administer the company’s 401(k) plans. Common administrators are Fidelity, Charles Schwab, and T. Rowe Price.

The investment options available to you depend on your employer’s plan and the administrator. You should have a selection of stocks, bonds, and money market funds. One of the most common investments in a 401(k) is a target date fund, which helps you automate investing through a fund that adjusts as you near retirement.

Once you reach 59 1/2, you can begin to withdraw the money from your 401(k). Your withdrawals count as regular income for tax purposes, but as mentioned, you’re saving in the long run by putting your money in a 401(k). The money you withdraw from a 401(k) is known as a distribution.

Once you reach 70 1/2, the IRS requires you to withdraw at least a certain amount annually. These are required minimum distributions (RMDs). The amount of your RMDs depends on your age and the balance of your account. If you don’t make the RMDs, the IRS will charge a big penalty worth 50% of the RMD. So if your RMD is $5,000 and you miss it, you will pay a penalty of $2,500.

The origin story of the 401(k) plan

The 401(k) plan as we know it today began as an accident. In 1978, Congress passed the Revenue Act of 1978 into law. It made multiple tweaks to the U.S. tax code and created flexible spending accounts. One section of the act—Section 401(k)—allowed employees to defer some of their income, pre-tax. When the new law took effect in 1980, Ted Benna, a consultant on retirement benefits, used Section 401(k) to help create the first version of what has become the 401(k) plans we have today.

Types of 401(k) plans

There are two main types of 401(k) plans: the traditional and the Roth 401(k).

Traditional 401(k) plans

A traditional 401(k) plan is what we’ve been discussing thus far. You contribute pre-tax income and when you withdraw the money, you pay income taxes.

Since most employees have a higher annual income now than they will at retirement, a traditional 401(k) is most beneficial. If you think that your annual income will be higher when you retire, you may want to consider a Roth 401(k) plan.

Roth 401(k) plans

Roth 401(k) plans allow you to contribute money post-tax. You pay income taxes before you contribute and then you don’t need to pay any taxes when you withdraw. If this type of account sounds familiar, that’s because it works in the same way as a Roth IRA.

A Roth 401(k) is useful if you think your annual income in retirement will be more than it is now. This mostly applies to people who have an entry-level position or are early in their careers, like recent college graduates.

Roth 401(k) plans didn’t exist until the early 2000s and because they’re still so new, most employers don’t offer them yet.

How to contribute to a 401(k)

If your employer has a 401(k), you most likely need to sign up in order to begin using it. It’s also common for employers to require that you work there for a certain amount of time before you can enroll.

When you enroll, you select how much you want to contribute. This works as a percentage of your income. For example, you may want to contribute 10% of your income. That contribution will automatically come out of each paycheck and go into your 401(k).

How much should you contribute?

Everyone has different retirement needs but the basic advice is to contribute as much as you can. The average person doesn’t have enough retirement savings so there’s really no harm in saving more if you can.

As a general rule of thumb, financial experts advise that you save at least 10% to 20% of your gross annual income for retirement. Your individual needs may differ but this is a good place to start.

If your employer has a matching program, you should always try to contribute enough to get the maximum employer match.

How employer matching works

One fantastic perk that some employers offer is a matching program: When you contribute to your 401(k), your employer will match some or all of your contribution.

Let’s say your employer offers a 100% match on the first 5% of your salary. For any contributions you make that are worth up to 5% of your annual salary, your employer will contribute an equal amount.

So if you make $50,000 and contribute $2,500 (5% of salary), your employer will also contribute $2,500. If you contribute $5,000 (10% of salary), your employer will only contribute $2,500 because 5% of your salary is their maximum contribution level. If you only contribute $1,000 (2% of salary), then your employer will match 100%.

You should always try to contribute enough to get the maximum match because an employer match is free money.

Policygenius Image

Ready to start investing?

Policygenius is partnering with Wealthfront to help you invest in your future.

401(k) contribution limits

There is a limit to how much you can contribute to your 401(k) each year.

For most employees, the annual limit for 2019 is $19,000. The contribution limit will increase to $19,500 for 2020.

If you are 50 or older in 2019, you can make an additional catch-up contribution of $6,000, bringing your total annual limit to $25,000. In 2020, the catch-up contribution increases to $6,500, meaning that you can contribute up to $26,000 in 2020 if you're over 50.

There is also a limit on the total contributions that can go into your defined contribution plans each year. This limit, which is $56,000 for 2019, includes your own contributions as well as employee match. The defined contribution limit will be $57,000 in 2020.

The only big exception to these limits is if you earn at least $125,000 or own more than 5% of the company. In that case, the IRS considers you a “highly compensated employee” (HCE). To ensure that company retirement plans don’t unequally favor HCEs, the IRS limits how much those individuals can contribute. In general, the average 401(k) contribution from HCEs cannot be more than the average contribution of non-HCEs by more than 2%.

So if the average for non-HCEs is 3% of salary, an HCE can only contribute up to 5% of their salary. Some small business owners can get around this restriction with a safe harbor 401(k). This type of 401(k) has its own rules and requirements, so make sure to consult an accountant or financial adviser if you think you need one.

Additionally, there’s a limit on the amount of your income that an employer can use when calculating a match: $280,000. So if your annual income is $300,000 and your employer matches the first 5%, the maximum they could contribute would be based on 5% of $280,000 and not $300,000.

How taxes apply to 401(k) contributions

As mentioned, you only pay income taxes on 401(k) contributions when you withdraw the money. Contributions come out of your paychecks, which decreases your take-home pay, but deferring your pay is worth it because of the long-term tax savings. The tax benefits make your 401(k) a “tax-advantaged” account.

The first reason you’re saving is that your annual income is usually lower when you retire than it is when you’re in the middle of your working life. By deferring some income you also decrease your taxable income for the year. You may even lower the income tax rates you pay if you contribute enough to push you into a lower tax bracket.

The other big tax advantage of 401(k) plans is that you don’t pay taxes as your investments earn money within the account. This differs from regular investing accounts, which require you to pay capital gains taxes on investment earnings.

One thing to note is that 401(k) contributions aren’t entirely tax-free. You defer income taxes but you still pay FICA taxes based on your gross earnings. That includes 401(k) contributions. You pay FICA taxes because they fund medicare and other benefits you can use when you retire.

What if you change employers?

When you leave an employer, you don’t lose any of your 401(k) money, but you can no longer contribute through that employer’s plan. You have a few options for how to manage that money.

  1. Leave the money
  2. Transfer the money into a new 401(k)
  3. Move the money into an IRA

If you’d like, you can simply leave the money alone. It will continue to earn money and you can make withdrawals once you reach 59 1/2. Transferring the money to a new 401(k) will make it easier to track how much you have and it’s a painless process. You just need to reach out to your old employer or the plan administrator. They’ll likely give you some forms to fill out and then they’ll handle the rest of the work. Alternatively, you can move the money from the 401(k) into a traditional IRA and manage it yourself. Transferring money from one 401(k) into another one or into an IRA is called a rollover.

Here’s a further breakdown of your 401(k) options when you change employers.

Policygenius Image

Your home may be your most important investment of all. Make sure it’s protected with homeowners insurance.

Policygenius can help you get coverage that fits your finances.

Policygenius’ editorial content is not written by a certified financial planner or advisor. It’s intended for informational purposes only and should not be considered legal, financial, or investment advice. Consult a professional to learn what financial products are right for you.

This post contains references to products or services from one or more of Policygenius' advertisers or partners. While these codes earn us a small fee at no additional cost to you, they do not influence editorial content and we only refer products we love.