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What is a 401(k)

What is a 401(k)
Holly Johnson
Updated October 12, 2021
8 Min Read

A 401(k) plan is an employer-sponsored retirement account used by traditional workers. Individuals who use these accounts can typically choose from a range of investments that often include mutual funds, index funds, exchange-traded funds and target date funds, among other choices. 

One important feature of the 401(k) is the fact that contributions are tax-advantaged, meaning money contributed now is added to their plan tax-free and only taxed when distributions are taken. Contributing to a 401(k) plan also gives employees the benefit of reducing their taxable income, so they have the potential to lower their tax bill substantially.

You may be wondering why this account is described using a combination of numbers and the letter "k." Also, how did the 401(k) come to fruition in the first place?

By and large, the 401(k) account got its name when Congress passed the Revenue Act of 1978, which included a change that let employees contribute to a retirement plan without being taxed on those contributions. The section that was added to the Internal Revenue Code at the time was called Section 401(k). The Revenue Act of 1978 became law on January 1, 1980.

From there, a benefits consultant known as Ted Benna became the first company owner to offer a 401(k) plan to eligible workers.

Today, 401(k) plans have become the predominant savings vehicle for the majority of American employees. According to data from the Bureau of Labor Statistics, 67% of private industry workers had access to an employer-provided retirement plan, usually a 401(k), as of March 2020. 

How Does a 401(k) Work?

Employees can make contributions to a 401(k) plan through payroll deductions, which makes the process seamless and convenient. Employees can contribute up to $19,500 to a 401(k) plan in 2021, although individuals ages 50 or older can add another $6,500 per year to their accounts using what is known as a "catch-up contribution." Contribution limits are typically adjusted every few years to account for inflation.

Also note that, in many cases, employers will offer matching funds when employees contribute to their accounts. 

This "employer match" can be given as a set amount each year, or in the form of a matching contribution of up to a percentage of the worker's pay. Some matching funds automatically become yours when they are added to your 401(k) plan, although others become entirely yours based on a "vesting schedule." 

While 401(k) plan vesting schedules vary dramatically, they typically let you increase the amount of funds you have vested for each additional year you remain with the company. Your vesting plan could be graded, meaning you see more of your funds vested as a percentage for each year you work. You can also become fully vested once you reach a specific threshold, such as two years with the company.

Employees who contribute to their workplace 401(k) can pick from available investments in their plan, although options can vary dramatically based on your employer and the account administrator. Otherwise, the contributions employees make will be invested in a Qualified Default Investment Alternative (QDIA). 

The QDIA is an investment option that is selected by your plan fiduciary as the default option for all employee accounts. Most QDIAs are target date funds, which are chosen based on the anticipated year of retirement with a mix of investments that become more conservative as time goes on.

What Are the Benefits of a 401(k)?

401(k) plans come with a range of important benefits, although some of the upsides can vary depending on your specific situation. Advantages that come with investing in a 401(k) plan can include the following:

  • Your 401(k) belongs to you. While your 401(k) plan is offered by your employer, you own your account and all of the vested funds inside. This means that, if you switch jobs or quit working, you have the option to keep your plan where it is or roll your 401(k) over to a new plan administrator.
  • Contributions through payroll deductions are a major plus. The 401(k) plan lets workers contribute via payroll deductions, which means money automatically goes into the account several times per month. You don't have to plan for it or worry about making the transfer.
  • Lower your taxable income. Contributions to a 401(k) plan are tax-deferred, meaning you don't pay upfront taxes on the income you contribute to your account. This also means you can lower your taxable income, and potentially your tax bill, every year you contribute.
  • Plan participants get tax-free growth. Money added to a 401(k) plan gets the benefit of tax-free growth and compounding. You only pay income taxes on your 401(k) when you begin taking distributions.
  • You could get a match from your employer. Some employers offer a match on funds their workers contribute to a 401(k) plan, which is the closest thing to "free money" most people will ever find.

Types of 401(k) Plans

There are many different types of retirement accounts, including several types of 401(k) plans used by traditional employers. 

  • Traditional 401(k): This type of 401(k) works exactly how we have described in this guide so far. Individuals can contribute up to the Internal Revenue Service (IRS) maximum contribution limit each year, and the contributions they make to their account are tax-advantaged. The money grows tax-free in their account during their working years, and taxes are only owed on distributions made from the account later on.
  • Roth 401(k): A Roth 401(k) is similar to a Roth IRA in the fact users make contributions on an after-tax basis. The same contribution limits apply, with the big difference being in when you pay taxes. Since you pay income taxes on money you put in a Roth 401(k) upfront, your money gets the chance to grow tax-free and you don't have to pay taxes on distributions in retirement.
  • Simple 401(k): The Simple 401(k) is a retirement plan geared to businesses with 100 or fewer employees. Workers can only contribute up to $13,500 to this plan in 2021 (and an additional $3,000 per year if they're ages 50 or older), which makes it less beneficial than a traditional plan that allows higher contribution limits. However, the employer is required to match some of the funds in this type of account — either a matching contribution up to 3% of each employee’s pay or a non-elective contribution of 2% of each eligible employee’s pay.
  • 403(b): The 403(b) is not a 401(k) plan, but it's worth mentioning since it works similarly. This type of account is the 401(k) equivalent for schools, universities, non-profit organizations, and churches. In 2021, individuals can contribute $19,500 to a 403(b) plan as well, although individuals ages 50 and older can contribute an additional $6,500 per year. Additionally, workers who have stayed with a qualified organization for 15 years or longer can become eligible to make an additional $3,000 per year in contributions for up to five years. 

Withdrawing Funds from a 401(k) Plan

Whether you have a traditional 401(k), a Roth 401(k), a Simple 401(k) or a 403(b), you can begin taking distributions from your account without penalty once you reach age 59 ½. If you want to take distributions from your account before that age, you'll typically pay a 10% penalty unless you qualify for a handful of exemptions.

Tax-advantaged plans like a traditional 401(k) require users to pay income taxes on their withdrawals at the current tax rate, whatever it is. However, Roth plans that were funded with after-tax money allow you to withdraw funds without incurring any tax consequences or liability.

Also note that Required Minimum Distributions (RMDs) will apply to most plans, including the traditional 401(k) account, once you reach age 72. This means you'll eventually have to begin taking money out of your 401(k) and paying taxes on it — even if you don't really need to. The amount of your RMD can be determined using specific worksheets provided by the IRS

How Do You Get a 401(k)?

Qualifying for a 401(k) plan requires you to work for an employer who offers one. The good news is, the majority of companies do offer some type of retirement plan for eligible employees, or those who work full-time. 

To get your 401(k) plan up and running, you'll need to enroll through your workplace Human Resources (HR) department if your employer didn't do so automatically. From there, you'll choose your account type (if you have an option between a traditional 401(k) or a Roth) and you'll select your investment options.

Make sure to compare fees charged by your 401(k) plan administrator. Also ask about any matching funds you may receive from your employer, as well as how much you need to contribute to maximize this important benefit. For most workers, it makes sense to contribute enough to max out all matching contributions from an employer at the very minimum.

401(k) Alternatives

If you are not offered a 401(k) through your workplace, you can still open a retirement account and begin saving for the future. A few options to consider include the traditional IRA and the Roth IRA, both of which come with a combined contribution limit of $6,000 in 2021. Individuals ages 50 and older can contribute an additional $1,000 across either account (or both) for a total of $7,000 in contributions per year.

With a traditional IRA, you can deduct contributions on your taxes in certain situations, such as if you and your spouse are not covered by a retirement plan at work. Either way, your contributions are able to grow tax-free, and you only pay taxes on the money once you take distributions in retirement.

With a Roth IRA, on the other hand, you can contribute to the account with after-tax dollars provided your income doesn't exceed the threshold set by the IRS. From there, your money grows tax-free and becomes a tax-free source of income for retirement. With a Roth IRA, you can even withdraw your contributions (but not earnings) tax-free at any time.

If you're self-employed, you can also consider 401(k) alternatives like the SEP IRA and the Solo 401(k). These accounts also let you save for retirement on a tax-advantaged basis, and they come with much higher limits for contributions.

The SEP IRA lets you contribute 25% of your compensation up to a maximum limit of $58,000 in 2021. If you're self-employed, however, your contributions are typically capped at 20% of your net income. 

The Solo 401(k) lets you contribute as the employer and the employee. You can defer up to $19,500 of your compensation in 2021 as an employee. On the employer end, you can contribute another 25% of your compensation as defined by your plan for a maximum limit of $58,000 in 2021.

Frequently Asked Questions (FAQ)

What happens to my 401k if I change jobs?

You own your 401(k) plan, so nothing happens to your funds if you switch jobs. You can leave your 401(k) plan to grow and compound where it is if you like the investments available to you and you're happy with the fees you're being charged. 

However, you can also roll over your 401(k) plan to a brokerage firm or account administrator of your choosing. For example, you can roll over your old 401(k) plan to a firm like Vanguard or Fidelity.

What are the penalties if I cash out my 401(k) early?

Individuals who take money out of their retirement before age 59 ½ can expect to pay a 10% early withdrawal fee as well as any income taxes they owe on distributions. However, there are exceptions you can qualify for based on disability, the purchase of a first home, and more. 

Can I contribute 100% of my salary to my 401k?

You can contribute 100% of your income to your 401(k) plan provided you earn less than the annual contribution limit, which is $19,500 in 2021.

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