What is a 401(k)? Everything you need to know

Even though many are contributing to 401(k)s, you may still have questions. Some may still be wondering: What is a 401(k) and how does it work? Read on to learn the basics, how these retirement accounts work, and whether its the right plan for you.

What is a 401(k) plan? 

A 401(k) is a type of plan thats offered by employers to help workers save for retirement. Employees can choose to deposit their paycheck into the account throughout the duration of their employment, and then funds can then be invested in a variety of assets such as stocks, bonds, mutual funds. What youre able to invest in will typically depend on your employer planand its often common for your company to match your contributions up to a set percentage of the employees income.

Employers typically prefer 401(k) plans instead of pensions and defined benefit plans because the employee is responsible for investing and managing their retirement contributions, says Doug Buddy Amis, certified financial planner and president and CEO of Cardinal Retirement Planning, Inc.

Traditional vs. Roth 401(k)

When setting up your 401(k), youll need to decide whether you want your contributions to go in pre-tax or after-tax (or both).

A traditional 401(k) allows you to contribute pre-tax dollars, meaning the funds come straight out of your paycheck before taxes are deducted. This allows you to contribute a larger percentage of your earnings, and also helps reduce your taxable income. When youre ready to take money out during retirement, you pay taxes on the withdrawals since the contributions werent taxed at the time the money went into the account. 

A Roth 401(k) works the opposite way. You pay taxes up front on your contributions, then your money grows tax-free. You dont have to pay any taxes on withdrawals during retirement. Although contributions to a Roth 401(k) dont help reduce your taxable income today, they may allow you to avoid paying high taxes in retirement. For example, a Roth can be a good place to hold less tax-efficient investments, such as actively managed funds and taxable bonds. If you think youll be in a higher tax bracket during retirement, opting for a Roth could help you save money, too. 

However, most people expect to be in a higher tax bracket while working and a lower tax bracket in retirement, Amis says. For individuals in this scenario, a pre-tax contribution can make your money last longer because you defer taxation from a period of high marginal taxes to retirement with lower marginal taxes. Plus, not all employers offer Roth 401(k)s.

How does a 401(k) work? 

A 401(k) plan is typically set up and sponsored by an employer. It's designed to encourage employees to save for their retirement by offering tax advantages, and sometimes, matching contributions. These plans are also protected by federal law; the Employee Retirement Income Security Act of 1974 sets a minimum standard for employers who choose to offer these retirement plans.

You can elect to contribute a portion of your salary to a 401(k) plan, which is done through payroll deductions. However, there are caps on how much you can contribute per year. As of 2023, the maximum annual contribution limit is $22,500 for individuals, with an additional $7,500 in catch-up contributions allowed for those aged 50 and older. (More on contribution limits later).

Additionally, like other types of retirement accounts, 401(k)s come with age-based restrictions, says Joe Allaria, partner and wealth advisor at CarsonAllaria Wealth Management. If you withdraw your money before you reach age 59 ,  youll face hefty taxes and penalties. 

For one, the IRS automatically withholds 20% of withdrawals for taxes. So if you were to take out $10,000, you would only get $8,000. You may get some of this back when you file your tax return, though, once your withholdings and liabilities are reconciled. 

Youre also charged a 10% penalty on early withdrawals. In our example, that would mean another $1,000 would go to the government, leaving you with $7,000 out of a $10,000 withdrawal. 

There are exceptions, however. For example, Allaria notes that some plans may allow withdrawals at age 55 if you leave your employer that calendar year. The exception is known as the rule of 55, which applies only to current 401(k) plans and not those held at previous employers. Additionally, you may be able to make penalty-free early withdrawals in the case of a financial hardship. The plan would need to allow hardship withdrawals, and the individual would need to provide proof of a qualified hardship in order to request a withdrawal, Allaria says. Regardless of the reason, you still need to pay income taxes on early withdrawals, even if you aren't subject to the 10% penalty.

Required minimum distributions

To prevent you from keeping tax-advantaged investments in your 401(k) indefinitely, the IRS requires you to start taking money out of your account eventually. For tax year 2023, you must start taking withdrawals once you reach age 73 (or age 75 starting in 2033). This is known as a required minimum distribution (RMD), or the minimum amount of money youre required to withdraw each year. The exact amount youre required to withdraw is based on a calculation that considers your total account balance and life expectancy.

If you dont take your distribution, or you dont pull out enough, you could have to pay a 25% excise tax (down from 50% previously) on the amount that wasnt distributed as required. But if you fix your mistake in a timely manner, that tax drops to 10%. Note that starting in 2024, RMDs arent required for Roth 401(k)s.

Contribution matching

As an added incentive to save, some employers will offer to "match" a portion of your contributions. For example, your employer may match your contributions dollar-for-dollar up to a certain amount, or they may match a certain percentage of your salary.

This is a distinct advantage that can help supercharge retirement savings because the employer will add money alongside your salary deferrals, Amis says. He notes that the exact amount can vary by company and industry. At the very least, Amis says you should contribute enough to your 401(k) to receive a full match, otherwise youre saying no to free money. 

Vesting

The term vesting refers to the ownership of funds in your 401(k). Your vested balance is the amount that you own and would keep if you left your employer. Money that you personally put into your 401(k) is always 100% vested from day one. However, matches by your employer may vest according to a schedule (usually, over a few years), meaning you might have to give back a portion of those matches if you leave the company before the vesting period is over.

401(k) loans

Another benefit of a 401(k) is that you may be able to borrow against its valueif your employer allows it. A 401(k) loan allows you to borrow up to 50% of your vested balance, up to a maximum of $50,000. Youre required to repay the loan, plus interest, within five years. That is, unless youre using the money to buy a primary home, in which case you might get more time.

There is no credit check required to get a 401(k) loan and its not reported to the credit bureaus since youre essentially borrowing from yourself. You also pay interest back to the account. Despite these perks, you should carefully consider borrowing from your 401(k), as it might mean missing out on substantial returns if the stock market is doing well. Plus, if you leave your job while the loan is outstanding, you may have to pay it all back right away. And if you dont repay your 401(k) loan according to schedule, you could be subject to income taxes and a 10% penalty on the balance.

401(k) contribution limits 

The amount you're allowed to contribute each year to a 401(k) is capped. These limits are adjusted from time to time to account for cost-of-living increases. For example, the maximum you can contribute to a 401(k) for tax year 2022 is $20,500, while the limit for tax year 2023 is $22,500. 

Additionally, those aged 50 and up are allowed to make additional catch-up contributions totalling $6,500 for 2022 and $7,500 for 2023. These limits are the same for traditional and Roth contributions. 

Keep in mind that these contribution limits only apply to money you personally put into your 401(k). Employer matches dont count toward these totals.

If you contribute more than the maximum allowed in a year, youll need to move those funds out of your 401(k) by the tax filing deadline of the following year to avoid being penalized. (This applies only to your contributions, not any matches made by your employer.) Excess contributions that are withdrawn in time are added back to your gross income for that year. However, if you fail to take the money out, you get double-taxed on the excess portiononce when you deposit it, and again when you withdraw it. 

Pros and cons of a 401(k)

Overall, Allaria says that 401(k) plans provide a good place to save and invest for retirement. Many are easy to sign up for and manage, he adds. An appropriate target-date fund combined with a focus on saving as much as possible into the plan is enough to get most on the right track for retirement. Some employers may offer additional benefits, such as matching, 401(k) loans, and Roth contribution options.

The main downside of these plans is that they come with several restrictions, Allaria says. So it's important that investors have a sufficient emergency fund available, just in case they need to access a portion of their money in the short-term.

401(k) Alternatives

You can only contribute to a 401(k) if your employer offers oneand many dont. However, that doesnt mean youre out of luck if you dont have access to a 401(k). There are other types of retirement and investment accounts that can help you grow your wealth.

• Solo 401(k): If youre self-employed with no employees, you may be able to save for retirement using a solo 401(k). The structure is similar to a traditional 401(k), though youre able to make contributions as both an employee and employer, which means the contribution limits are higher. 
• Individual retirement arrangement (IRA): These retirement plans work similarly to 401(k)s, except you can open one on your own. There are traditional and Roth IRAs available, as well as IRAs designed for self-employed individuals and business owners. The annual contribution limits are different for these accounts, however. Amis also notes that you need to have earned income in order to contribute to an IRA, but there may be exceptions if you are married and your partner works.
• Health savings account (HSA): If you have a high-deductible health plan, you may have access to an HSA. Although these investment accounts are designed to help you pay for qualifying medical expenses using pre-tax dollars, the funds can also be used for other purposes once you reach age 65. As of 2022, you can contribute up to $3,650 per year for self-only coverage and up to $7,300 per year for family coverage.
• Taxable brokerage account: You can also open an investment account with any brokerage and choose your own investments. Plus, you can contribute as much as you want. Those accounts are treated differently from a tax perspective, but they could be used if investors have maxed out or exhausted all other retirement account options, Allaria says.

The takeaway 

A 401(k) is a popular type of retirement savings account offered by employers. Taking advantage of a 401(k) can help you grow your wealth faster thanks to tax benefits and other perks such as employer matching. That said, its important to understand all of the rules surrounding 401(k)s, since incurring any penalties can easily wipe out your investment returns. 

Whether or not you have access to a 401(k), be sure to investigate the retirement savings options you have available and make a plan to get started. Reaching your retirement goals is all but impossible unless you invest a portion of your earnings.