What is a 401(k)?
A 401(k) is a type of retirement savings plan provided by an employer.
Employees who sign up for a 401(k) decide how much of their paycheck they’ll contribute each month and how to invest it. The employer often matches a percentage of that contribution every month.
Any money added to a 401(k) receives a tax break. The tax break either comes when you contribute the money or when you retire and withdraw the money – depending on your plan.
Learn how a 401(k) works and how to make the most of this employer-sponsored benefit.
There are various types of 401(k) plans, but the two main types are a traditional 401(k) and a Roth 401(k). What is a Roth 401(k) and how does it compare to a traditional 401(k)? Let’s break it down.
The tax benefits are received upfront in a traditional 401(k). Since your contributions are withdrawn from your paycheck, you fund your account with pre-tax dollars, meaning your taxable income is lower. If your yearly income amounts to $65,000, and you contributed $5,000 to your 401(k), only $60,000 will be taxed. Keep in mind that once you begin withdrawing funds during your retirement, your earnings will be fully taxable.
On the other hand, contributions to a Roth 401(k) are made with after-tax dollars. This means when you begin withdrawing funds during your retirement, you won’t have to pay any income tax on qualified distributions. A Roth 401(k) is beneficial if you think you’ll be in a higher tax bracket at the time of your retirement.
Roth 401(k)s are a good option for those beginning their careers at lower income levels. Depending on which type of 401(k) your employer offers, you may be able to invest in both.
Depending on where you work, your employer may offer a 401(k) and match your contributions. How much they contribute to your 401(k) will be up to your employer. For example, an employer may offer a dollar-for-dollar amount to equal 3% of your salary. Meaning if you choose to contribute 5% of your annual pay and receive $2,500 every pay period, then you would be adding $125 every paycheck to your 401(k), and your employer would contribute $75.
Some employers may choose to do a partial match or $0.50 per dollar to equal 5% of your salary. You would have to put in 6% to get the most for your match. However, if you put in more, your employer would still only match half of 6% of your salary.
If your employer offers a 401(k) and matching contributions, be sure to capitalize on this benefit. If you’re asking, “How much should I contribute to my 401(k)?”, the answer is as much as you can. To receive the most benefits, set your 401(k) contributions to get the full match and take advantage of the free money your employer offers.
However, there is a cap on how much you can contribute to your 401(k). To account for inflation, the maximum amount an employer and employee can contribute is adjusted yearly. For example, in 2023, employees under the age of 50 have a contribution limit of $22,500 per year, while those 50 and over can add an additional $7,500 in catch-up contributions.
The sooner you start contributing to a 401(k), the quicker compound interest can help boost your potential earnings. Compound interest allows you to earn interest on both the money you saved and the interest you earned. Over time, your compound earnings can be larger than the contributions you made to your 401(k).
If your employer doesn’t offer a 401(k), there are other retirement savings options. An IRA (individual retirement account) is an investment account you can open on your own that also provides tax advantages.
Your 401(k) will offer different investing options. These options typically include a mix of mutual funds, index funds and exchange-traded funds. You can decide how much of your 401(k) balance you want to invest in different funds or allow your plan to automatically enroll you. Regardless of what you choose, you’ll be able to change your investments at any time.
If you’re unsure how to invest your contributions, a financial professional can help you determine the right mix for you based on your age and risk tolerance.
Typically, you can withdraw from a 401(k) without penalties when you’re 59 ½ years old. Whether you have a traditional 401(k), Roth 401(k) or both, you’ll need to start taking required minimum distributions (RMDs) once you reach age 73. Note that a provision in the SECURE 2.0 Act eliminates RMD requirements for workplace-based Roth plans beginning in 2024.
The amount you’ll be required to withdraw will depend on your age and the balance in your account. Once you reach retirement age you can withdraw as much as you like, either in a number of withdrawals or one lump sum.
You can borrow money from your 401(k), but early withdrawal may lead to a 10% penalty fee, federal income tax, state income tax and other related taxes. However, the IRS does allow for certain exceptions regarding financial hardship. Here are some scenarios in which you may be able to withdraw from your 401(k) penalty-free:
Tuition and fees for the employee, spouse or a dependent
Medical expenses for the employee, spouse or dependent
Certification from a physician as having a terminal illness
Other occurrences exempt from having to pay penalty fees are:
A Qualified Domestic Relations Order issued as part of a separation or divorce
Purchase of a first residence (yes, you can use your 401(k) to buy a house)
Note that restrictions may apply, so be sure to consult with a financial and tax professional to fully understand the rules and tax ramifications.
What happens to your 401(k) when you leave the job where your plan is held? There are a few options for your 401(k) whenever you change jobs, which include:
Cash out your earnings. This option gives you immediate access to your money. However, your funds may be subject to a 20% federal income tax penalty, a 10% penalty for early withdrawal (if you’re younger than 59 ½), and other state and local taxes.
Leave funds in your former employer's retirement plan. While this option allows your investment continued growth and earnings are tax-deferred until withdrawal, you won’t be able to make additional contributions. Additionally, you’ll still be subject to a tax penalty for early withdrawals before age 59 ½. Lastly, you’ll need to keep track of multiple 401(k) accounts if you leave your money with your previous employer.
Transfer funds into your new employer's retirement plan option. You’ll be able to continue making contributions and manage the rolled-over money and new contributions collectively. Your earnings will be tax-deferred until withdrawal, but subject to a tax penalty for early withdrawals before age 59 ½.
Roll funds into an outside IRA, such as a robo-advisor account. A direct 401(k) rollover to an IRA will not incur federal income tax and earnings are tax-deferred until withdrawal. Note that account fees may be higher than your employer-sponsored plan. Early withdrawals before age 59½ are subject to a tax penalty, and indirect rollovers may incur a 20% federal income tax penalty.
A few other considerations as you decide which option is right for you:
Some plans may allow you to do a trustee-to-trustee transfer of funds or roll over your old account into your new employer’s plan. You can also choose a trustee-to-trustee transfer into an IRA instead. In both instances, ensure you’re rolling your traditional 401(k) into another 401(k) and your Roth 401(k) into a new Roth 401(k).
If you have less than $1,000 in your account, your employer can write you a check for the balance. You’ll then have 60 days to reinvest it with a new company’s 401(k) plan or an IRA. After 60 days, you’ll face the 10% tax penalty and income tax.
Learn more about your 401(k) rollover options.
A rollover of qualified plan assets into an IRA is not your only option. Before deciding whether to keep assets in your current employer's plan, to roll assets to a new employer's plan, to take a cash distribution or to roll assets into an IRA, clients should be sure to consider potential benefits and limitations of all options. These include total fees and expenses, range of investment options available, penalty-free withdrawals, availability of services, protection from creditors, RMD planning, and taxation of employer stock. Discuss rollover options with your tax advisor for tax considerations.