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

Build your retirement savings while deferring income taxes with this employer-sponsored plan.

Derek Silva

Derek Silva

Published May 12, 2020

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KEY TAKEAWAYS

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

  • 401(k) contributions are pre-tax income and you only pay income taxes when you withdraw money

  • The 401(k) contribution limit for 2020 is $19,500, with an additional contribution of $6,500 available to people age 50 and older

  • An employer match is free money, with your employer contributing up to a set percentage of your income

The 401(k) is a qualified retirement plan that an employer can open to help their employees save for retirement. A 401(k) takes pre-tax contributions; money is taken out of your paycheck and invested before income tax is removed. You won’t have to pay income tax until you withdraw money later in life.

In 2020, the maximum contribution to a 401(k) plan is $19,500 per year (up from $19,000 in 2019). Some employers also offer matching contributions. Through an employer match program, the employer will contribute a set amount of what you contribute, based on a percentage of your income. An employer match is free money for you, so always try to contribute enough to get the full match.

Since starting in 1980, 401(k) plans have become one of the most common retirement plans today. They have largely replaced pension plans, a type of defined-benefit plan that paid a set retirement benefit when you retire; a 401(k) is considered a defined-contribution plan, since you contribute a set amount but the amount you have once you retire can vary.

How does a 401(k) work?

A 401(k) is an employer-sponsored retirement plan, meaning that employers open them for their employees. Not all employers offer them and some require you to work at the company for a period of time before you qualify.

You may also need to enroll in your company’s 401(k), which generally means making an online account and choosing how much to contribute. You won’t save any money in your 401(k) unless you enroll, but it’s becoming more common for employers to automatically enroll their employees.

The creator of a 401(k) is called the plan sponsor, and companies usually hire someone to administer the 401(k) plan. You need to go through the administrator to change contribution amounts or investments. Common plan administrators are Fidelity, Charles Schwab, T. Rowe Price, and Vanguard.

How 401(k) contributions work

You have the option to defer income from your paycheck to contribute it into your 401(k) account. Your contributions are pre-tax income, which means the money goes into your account without you having to pay income tax on it.

The money you contribute is also excluded from your income on your tax return, which can help you to pay a lower federal tax rate. That means if you made $100,000 in one year, but invested $10,000 of that in a 401(k), then you only need to pay taxes on the remaining $90,000, minus any other deductions you claim for that year.

Money is saved in your 401(k) as a percentage of your income. For example, you may choose to contribute 10% of your income into your 401(k), which a plan administrator or an account manager at the brokerage will invest on your behalf based on the plan options you choose. The exact investment options vary by plan, but you generally have a mix of index funds, 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 age.

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How to withdraw money from a 401(k)

Once you reach age 59½, you may withdraw the money from your 401(k). Withdrawing money from your 401(k) is known as taking a distribution. A distribution from a 401(k) counts as regular income for tax purposes in the year you withdraw it.

Taking an early withdrawal will result in a 10% penalty, with only a few exceptions. You are allowed to take a loan from your 401(k), but you need to pay it back in five years or you’ll face penalties. You may also be able to take a hardship withdrawal if you experience “immediate and heavy financial need,” like needing to pay health insurance premiums after losing a job.

In 2020, thanks to a provision in the CARES Act, you can make a larger 401(k) withdrawal if you experience financial hardship because of the coronavirus pandemic. Read more about the coronavirus and your 401(k).

Required minimum distributions (RMDs)

Once you reach age 70½, the IRS requires you to withdraw at least a certain amount annually. These are called required minimum distributions, or RMDs. Your RMDs depend on your age and the balance of your account. If you don’t make the full RMDs, the IRS will charge a big penalty worth 50% of each RMD.

The IRS has RMD worksheets to help calculate your RMDs.

How employer match works

One perk that some employers offer is a 401(k) matching program. With a 401(k) match, when you contribute to your 401(k), your employer will also contribute. An employer match is usually worth up to a certain percentage of your income, based on how much you contribute into the account. You should always try to contribute enough to get the maximum match because an employer match is free money.

As an example, let’s say your employer offers a 100% match on the first 5% of your salary. If you make $50,000 and contribute $2,500 (5% of salary), your employer will also contribute $2,500. If you contribute less than that, your employer will contribute the same amount as you. But if you contribute $5,000 (10% of salary), your employer will only contribute $2,500 because 5% of your salary is their maximum match.

With a partial match, your employer will match a portion of your contributions, up to a certain percentage of your salary. For example, an employer may match 50% of your contributions, up to 5% of your salary. So if your salary is $50,000 and you contribute $2,500 (5%) your employer would contribute 50% of that, or $1,250.

401(k) contribution limits for 2020

For most employees, the annual 401(k) contribution limit is $19,500, in 2020. The contribution limit was $19,000 for 2019. This limit does not include employer contributions. You can make an additional 401(k) catch-up contribution of $6,500 if you’re 50 or older, bringing your limit to $26,000. In 2019, the catch-up contribution was $6,000.

There is also a limit on your total annual contributions, which includes those from you and your employer. This limit is $57,000 for 2020, up from $56,000 in 2019.

401(k) contribution limits for highly compensated employees

If you earn at least $125,000 or own more than 5% of the company, the IRS considers you a “highly compensated employee” (HCE). To ensure that company retirement plans don’t unequally favor HCEs, the IRS generally limits the average 401(k) contribution from HCEs to no more than 2% of the average contribution from non-HCEs.

So if non-HCEs contribute an average 3% of their salaries, an HCE can only contribute up to 5% of their own 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 consult an accountant or financial advisor 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: $285,000. 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 $285,000 and not 5% of $300,000.

How much should you contribute to a 401(k)?

As a general rule of thumb, financial experts advise that you save at least 10% to 20% of your gross annual income for retirement. That includes 401(k) contributions and any other retirement accounts you have.

However, everyone has different retirement needs, so you should really just try to save as much as you can. At the very least, you should always try to contribute enough to get the maximum employer match (if your employer offers a match).

Learn more about how much retirement will cost in your area.

Traditional 401(k) plans vs Roth 401(k) plans

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

A traditional 401(k) plan is what we’ve been discussing thus far. You contribute pre-tax income and only pay income tax when you make distributions. For employees who have a higher annual income now than they will during their 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.

A Roth 401(k) plan allows you to contribute post-tax money. You pay income taxes just like you do for the rest of your income, your employer makes your contribution, 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 very similarly to a Roth IRA.

A Roth 401(k) is useful if you think your annual income will be higher in the future than it is now. This applies especially 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, many employers don’t offer them yet.

What if I change employers?

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

  • Leave the money and let it continue to grow as is.
  • Transfer the money into a 401(k) with a new employer.
  • Roll over the money into a traditional IRA.

If you simply leave money in an old employer’s 401(k), it will continue to earn money and you can make distributions once you reach 59½.

Transferring the money to a new 401(k) will make it easier to track how much you have and it’s usually a simple process. Reach out to the plan administrator and tell them you’d like to transfer your 401(k). They’ll likely give you some forms to fill out, and that’s it. You will need to get account information from the administrator of your new plan. You won’t pay any taxes or fees to do this as long as you make the transfer within a period of time specified by your former plan administrator.

When you move to an employer without a 401(k), you may consider transferring your money from the 401(k) into a traditional IRA. You would have to open an IRA with your bank or another online broker, and then you can manage the account yourself. Transferring from a 401(k) into another 401(k) or into an IRA is called a rollover.

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

The tax benefits of a 401(k)

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 (specifically, a tax-deferred account).

The first reason you’re saving is that your annual income is usually lower during your retirement 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. This has the same effect as taking tax deductions, and will decrease your annual taxes.

The other big tax advantage of 401(k) plans is that you don’t pay taxes as your investments earn money within the account. If you invest through a non-retirement brokerage account, you need to pay capital gains taxes based on the earnings of your investments.

Note 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.

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About the author

Personal Finance Expert

Derek Silva

Personal Finance Expert

Derek is a tax expert at Policygenius in New York City. He has written about multiple personal finance topics in the past, and his work has been covered by Yahoo Finance, MSN, Business Insider and CNBC.

Policygenius’ editorial content is not written by an insurance agent. It’s intended for informational purposes and should not be considered legal or financial advice. Consult a professional to learn what financial products are right for you.

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