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Updated October 14, 2023

What Exactly Is a 401(K) & How Does It Work?

What Exactly Is a 401(K) & How Does It Work?

What Exactly Is a 401(K) & How Does It Work?

Mike Zaccardi, CFA, CMT

Mike Zaccardi, CFA, CMT

Personal Finance

A 401(k) plan is an employer-sponsored retirement account whereby employees can elect to defer part of their salary to go towards investing for retirement. It’s also common for a company to contribute to your account through a 401(k) match, too. A 401(k) savings plan has many benefits including growing your wealth in a tax-advantaged way. Once you retire or move on to another employer, you can perform an IRA rollover.

Many folks have questions about how their 401(k) account works. They might also be confused by all the rules while being unsure how best to invest for the long haul. Let’s dive into some of the most important features of this popular retirement investment account.

What is a 401(k)?

According to the IRS, a 401k(k) is a feature of a qualified profit-sharing plan that allows employees to contribute a portion of their wages to individual accounts. 

Put simply, it’s an account available through your job that allows you to set aside money for retirement with certain tax benefits. The ICI Institute reports that there are about 60 million active 401(k) participants across the country with an average account balance that varies by age but ranges from under $50,000 for those in their 20s to more than $300,000 for people on the verge of retirement in their 60s.

The 401(k) account is actually somewhat new in the retirement investing world. It used to be that employers had so-called “defined benefit” pension plans in which the company would set aside money to fund your retirement. As time progressed, corporations realized it was a great deal for the workers but not so great for their bottom lines. A new retirement savings vehicle was crafted to put the burden of saving on the employee. It was called a “defined contribution” pension plan, or 401(k), and it began in 1978.

There are important plan rules with a 401(k). For one thing, the most you can contribute is $20,500, for calendar year 2022. (Annual contribution limits generally increase with inflation.) Also, plan participants (that’s like you and me) must begin taking withdrawals starting at age 72. There are key rules to avoid penalties, too, which we’ll cover later on.

How a 401(k) Works

A 401(k) account works by you contributing part of your salary to the plan on a pre-tax basis. That means you get a tax deduction in the current year and then pay income tax on withdrawals, which are typically done in retirement. The logic goes that your marginal tax rate during your working years will be greater than the tax rate you’ll have in retirement since you will no longer have a salary check rolling in every two weeks. So deferring paying income tax often makes sense, tax-wise.

What’s great about a 401(k) is that it’s an easy way to get on the path toward a secure retirement. The setup process is often done during your first week at a new job with your HR department’s help. Some firms even auto-enroll their employees and put their money into a default investment choice. When you set it up, you simply choose either a fixed-percentage amount to contribute each pay period to your account or you can choose a dollar figure. We’ll talk about how to pick your investments later. 

401(k) Benefits

Maybe the biggest benefit to regularly contributing to your employer-sponsored 401(k) plan is the ability to grow your net worth via tax-deferred investments. Assets that go up in value or those that pay out dividends and interest do not result in a big tax bill for you since you only owe tax upon withdrawal – ideally in retirement. 

Another benefit of an employer-sponsored 401(k) plan is that your company might offer a “matching” contribution. While not all employers have a match, a common structure is for a firm to kick in $0.50 for every dollar you put in, up to 6% of your salary. You can think of contributing up to the match like earning an instant 50% return on your investment using those numbers. It’s important to note that employer contributions are always with pre-tax dollars, so you’ll be taxed on that money upon withdrawal too.

What's also great about a 401(k) is that contributions to a regular 401(k) savings plan are tax-deductible in the current year. That can be a substantial savings, but you’ll still eventually owe Uncle Sam his cut. Here’s an example of how you can benefit by contributing to your retirement plan at work.

Let’s say your salary is $100,000 and you want to begin saving for retirement. You know that your company will match 50% of contributions up to 6% of your salary. You start by deferring 6% per pay period at the beginning of the year, so that’s $6,000 total. We’ll also assume you are in the 22% marginal tax bracket. Some quick math shows that you capture a $1,320 current-year tax savings. Additionally, your employer was nice enough to put in another $3,000 to your account. Not a bad deal!

Different Types of 401(k) Plans

A traditional 401(k) plan, or a regular 401(k), is the more well-known type. It can work best for people in a high marginal tax bracket who expect to one day retire into a lower tax bracket. For instance, if you can shave $10,000 off your taxable income today when you are paying a higher rate, say 32%, and then retire and have a low tax rate of just 12%, that difference is a huge tax win for you. It often requires the help of online calculators or even a professional financial advisor to formulate the right strategy.

A Roth 401(k) works similarly, but also the opposite, to a regular 401(k). Let us explain: With a Roth 401(k) plan, money going into the account is after-tax, so you do not get a current-year tax deduction. The upshot is that once your money is invested in the Roth 401(k), it has the chance to grow and eventually be withdrawn tax-free. A Roth 401(k) can make a lot of sense for young people just starting their careers who might be earning a low salary compared to what they expect to earn years and decades down the line. Locking in a low tax rate today by socking away money in a Roth 401(k) could be a savvy move.

What Are the 401(k) Contribution Rules?

Section 401(k) of the Internal Revenue Code was established by the IRS, so you know there’s a lot of fine print and specific rules you must follow. 

The annual limit on employee 401(k) contributions for 2022 is $20,500 plus an additional “catch-up” contribution of $6,500 for those age 50 and older. Those amounts will increase incrementally with inflation. 

It’s important to know that the calendar-year limit is not unique to any one account or plan type – it spans all of your 401(k) accounts if you have more than one job or if you contribute to both a traditional and a Roth 401(k). 

As employers can make both matching and non-matching contributions to an employees 401(k) there is also a maximum contribution rule sometimes encountered by highly compensated employees. In 2022, the total retirement contribution amount limit is $61,000 ($67,500 for those 50 and over) between employee and employer contributions.

For high-income earners, a 401(k) plan is particularly attractive since there is usually no income cap that restricts them from contributing. With Individual Retirement Accounts (IRAs), by contrast, there are income limits that can make those accounts either unappealing to contribute towards or unavailable altogether. Not all 401(k) plans are the same, however, so be sure to check with your HR department to find out about your plan’s rules.

How Do I Pick My 401(k) Investments?

This is where many people get tripped up. Choosing your 401(k) investment options is a straightforward process once you know the ground rules and just a little bit of asset allocation strategy. By picking a low-cost and diversified mutual fund or set of funds, you can be on your way to building long-term wealth. If you feel overwhelmed with that decision, you can always reach out to your HR department – the company might have a 401(k) plan sponsor representative who can help you with questions, but more detailed planning work is often done through an advisor. 

Arguably the easiest 401(k) investment is simply a target-date retirement fund (TDF). Most plans have TDFs these days. You simply choose the date you expect to retire (or ballpark it) and put all your contributions and investments in that fund. Now, you might say that seems risky – like placing all your eggs in one basket, right? Not so. A TDF automatically diversifies your account. It does the heavy lifting for you. What’s more, the fund periodically rebalances. You just want to be sure the fees are not high on the fund.

You can also select other mutual funds offered in the plan’s investment lineup to construct your own strategy, potentially at a lower cost using index funds. Some 401(k) plans even offer the “brokerage link” option whereby you can take your 401(k) cash and invest in stocks and exchange-traded funds (ETFs) through a big brokerage site. 

Are There Rules About Withdrawals I Should Know?

There sure are! But have no fear. Both traditional and Roth 401(k) accounts require that you be at least age 59½ before “qualified” withdrawal can begin. A qualified withdrawal is typically one that does not get slapped with an additional 10% penalty. Taking assets out of a 401(k) before you’re 59½ usually means you’ll face income tax on the amount withdrawn and a 10% early withdrawal penalty. 

There are certain exceptions to the early distribution penalty. The most common are related to death, disability, extreme medical expenses, and active military duty. If your situation does not fit into one of those requirements, you can still withdraw 401(k) money early if you’re between ages 55 and 59½ without penalty if you lose your job or just quit. 

Those looking to retire early can also take advantage of the Substantially Equal Periodic Payment (SEPP) policy which allows people to withdraw substantially equal annual amounts from their 401(k) based on life expectancy tables. This can be a complicated option, so seeking advice from a financial planner might be prudent.

Starting at age 72, you must begin taking annual withdrawals from traditional and Roth 401(k) plans by way of Required Minimum Distributions (RMDs) (Roth IRAs are not subject to RMDs during the account holder’s lifetime). An RMD amount is calculated using actuarial tables. There are costly penalties if you miss an RMD, so be sure all your ducks are in a row when tabulating accounts.

Common 401(k) Scenarios and Rollovers

Establishing and contributing to a 401(k) is usually the simple part. It’s when you leave a job or retire when more complicated decisions must be made. Let’s say you find a better job at a new company and you are unsure what to do about your old 401(k). You have a few choices. 

  1. You can perform an IRA rollover whereby you simply transfer your inactive 401(k) to a Rollover IRA at a brokerage company. This might be the best method since moving your assets to a low-cost broker can end up saving you on fees. You can perform Roth conversions later on, too. 

  2. Transferring the 401(k) to your new employer’s plan is also an option. This too can work just fine and cuts down on the total number of accounts you have open. There’s something to be said for simplicity!

  3. Leaving the account with your former employer’s plan sponsor is generally allowed. This is okay, but not ideal. 401(k) plans usually have some kind of annual maintenance fee, and the fund lineup is not always best from a cost perspective.

  4. Withdraw the 401(k) balance. This is often the worst choice since withdrawn 401(k) money is taxable and faces that 10% early distribution tax. 

When you retire, many advisors say that rolling over your old 401(k) to a no-fee Rollover IRA is a good play. That makes figuring out RMDs easier since the broker can do it for you and there are more investment choices available, including low-cost ETFs. Many retirees choose to perform strategic Roth conversions in their 60s after quitting work and before taking RMDs – a Rollover IRA can make that easier to do.

The Bottom Line

A 401(k) plan is a retirement investment account that so many of us have access to and use. There are important rules of the road, though, and missteps can result in paying excessive fees and taxes. Going about contributing to your 401(k) can fast-track your path to retirement. A great first step toward financial wellness is getting on your game when it comes to retirement savings.

Whether you’re seeking an expert team to manage  your money or looking to build your own portfolios with the best financial technology available, Allio can help. Head to the app store and download Allio today!


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