What Is a 401(k)? A Quick Look at What You Need to Know

If you’re planning for the future and you’re wondering what a 401(k) plan is and how it works, this article is for you.
Last updated Sep 1, 2020 | By Larissa Runkle
What Is a 401(k)?

FinanceBuzz is reader-supported. We may receive compensation from the products and services mentioned in this story, but the opinions are the author's own. Compensation may impact where offers appear. We have not included all available products or offers. Learn more about how we make money and our editorial policies.

Maybe you just landed a job with a generous 401(k) package, or maybe you’re starting to seriously look into retirement planning. Whatever the reason, understanding 401(k) plans and how they can help you achieve your goals is an important part of long-term financial planning.

Although the terminology might sound complicated, most 401(k) plans are relatively straightforward once you know the basics. Here’s the high level of everything you need to know about these savings plans, and how they can help you reach your personal finance goals.

Jump To

What is a 401(k) plan?

There are several types of 401(k) plans, but the most common and traditional one allows you to contribute pre-tax money from your paycheck into a retirement savings plan.

These traditional 401(k) plans are sometimes referred to as tax-advantaged because they offer certain tax benefits, mainly that you don’t have to pay income taxes on the deposited funds. You won’t pay taxes on that money until you withdraw from the account later in life. Because you can defer paying taxes until later, traditional 401(k) accounts are also sometimes called tax-deferred, which is seen as a type of tax advantage.

In addition to giving you a way to put pre-tax dollars aside, many employers will also offer what’s called a match. This means the employer matches the employee’s contributions to the account, typically up to a certain percentage. For example, if your employer offers a 3% company match, that means when you put aside 3% of each paycheck, your employer also contributes 3%. This is essentially free money that an employer offers along with any other benefits that come with a particular job.

Although 401(k) plans are seen as one of the main ways to save up for retirement nowadays, the plan pretty much started as an accident back in the 1980s. Following the Revenue Act of 1978, which allowed employees to avoid being taxed on deferred compensation, executive Ted Benna of the Johnson Companies came up with the idea (originally for a client) to allow employees to save pre-tax money into a retirement plan while receiving an employer match. Although his client rejected the idea, Benna adopted it, making the Johnson Companies the first to offer this type of retirement savings to workers.

How a 401(k) plan works

Now that you know a bit about 401(k) plans and how they got their start, here are some key aspects of these plans to keep in mind:

Contributions

As we mentioned earlier, 401(k) plans are set up on the basis that you will make regular elective contributions. That means you choose to put that money aside, but you’re not required to. Because these contribution amounts are determined in advance and deposited automatically on a recurring basis, 401(k) plans are also sometimes referred to as defined-contribution plans. That simply means you pick a percentage or amount to define your contribution and it automatically happens.

Although you might not be keen to give up part of your paycheck toward an automatic savings account, 401(k) plans are one of the easiest and best ways to save for retirement. Because you never see the money that goes into them, it’s easier to adapt to a smaller paycheck amount and resist spending that money before you put it aside.

Employer matching

Employer matching is essentially free retirement money, and you should consider doing everything you can to take full advantage of it. It simply means the employer matches some amount of the employee contributions made to the 401(k) plan.

The specifics of employer contribution programs can vary depending on the plan administrator (i.e. the company you work for). One company might contribute dollar for dollar for up to 3% of your salary, for example. Another might contribute 50 cents per dollar for up to 6% of your salary.

The best way to find out how much your company is willing to match is to ask someone in your human resources department. Familiarize yourself with the ins and outs of your employer match program, and then consider the steps you can take to max out the opportunity and take advantage of this valuable benefit.

Contribution limits

An important thing to keep in mind is that there are 401(k) contribution limits dictated by the Internal Revenue Service (IRS). Because putting money into your 401(k) plan allows you to get a tax break at the time of your contribution, the IRS sets a limit on how much you can put into the account each year. These limits are based on your age and put constraints on how much both you and your employer can contribute to the account in a year.

For example, for the tax year 2020, if you’re under the age of 50, you can contribute up to $19,500 to your 401(k) plan. If you’re over 50, you’re allowed an additional catch-up contribution becuase you’re closer to retirement age, and you can put up to $26,000 into your 401(k) plan.

Although the limits are set fairly high and a non-issue for most, it’s still good to make yourself aware of what they are when it comes to both your tax planning and retirement planning, especially because the numbers tend to change on an annual basis. You should also be cautious not to exceed contribution limits if you have a solo 401(k) or if your employer is putting money into your account in the form of non-elective contributions or profit-sharing.

A note about vesting

Because the act of matching your retirement contributions is seen as an investment by most companies, you’ll typically have what’s known as a vesting period before the money contributed by your employer actually becomes yours. This means that even if your employer contributes 3% of your annual income in your first year of work, you may not have access to that money right away.

Although vesting periods also vary by company, a typical vesting period is four years. This means that after four years of working for a company, you’d be able to leave and collect the entire value of their matching contribution. If you quit your job before the end of your vesting period, chances are you’d be considered partially vested and have access to only some of that money.

Depending on how much you plan to contribute to your 401(k) versus your other retirement accounts, it’s a good idea to plan on sticking with the same company for at least as long as the entire vesting period to get the full benefit of your employer’s contributions. When it comes to what you can do with a 401(k) after you leave a job, you’ll have a number of options including cashing out, doing a rollover to a new 401(k) plan, or even rolling your 401(k) over to an IRA (Individual Retirement Account).

How to withdraw money from a 401(k)

Withdrawing in retirement

Withdrawing from your 401(k) account typically happens around retirement age, which from a legal standpoint is 59 1/2 years old. Once you hit 59 1/2, you can take money out of your 401(k), but keep in mind that any money you take out will be treated as taxable income. If you take a distribution from your account before that age, you may be subject to an additional 10% tax penalty, also known as an early withdrawal penalty, and that can result in a surprisingly big tax bill.

There are a few exceptions to these penalties to keep in mind, and the IRS tax code regulates these exceptions under what’s commonly called the rule of 55. This provision in the Internal Revenue Code says that if you lose your job for any reason at age 55 or older and want to withdraw funds from your 401(k) plan, you can do so penalty-free. This provision also kicks in a few years earlier (at age 50) for public safety workers like firefighters and police officers. Keep in mind that no matter what age you take out money, you will have to pay taxes on it based on your current tax bracket.

Taking an early withdrawal

If you plan on withdrawing from your 401(k) early, you may end up paying a 10% penalty on top of the applicable income taxes. That being said, the CARES Act waives the 10% penalty for early 401(k) withdrawals in certain circumstances.

The CARES Act was passed to provide temporary relief during the COVID-19 pandemic and allows some people the opportunity to make penalty-free withdrawals from their accounts for reasons of financial hardship due to the coronavirus. Qualified individuals may also be eligible to take out a 401(k) loan for an increased amount as well.

If your finances have been impacted by COVID-19, be sure to consider all of your options before withdrawing from your 401(k), as it can be challenging to rebuild this type of savings later on.

Taking a 401(k) loan

Another way to use your 401(k) before retirement is by taking out what’s called a 401(k) loan. This is a loan taken out against the vested amount in your 401(k). Although the money can technically be used for anything, it’s best not to take out these kinds of loans lightly, especially because it puts you at risk of accruing even more debt to repay later.

If you are considering taking out a 401(k) loan to pay off debt, you may want to consider first speaking with a financial advisor so you understand all the potential ramifications.

Roll Over your 401(k)

If you have a 401(k) plan right now and decide to leave your current job, you’ll want to come up with a plan for handling your 401(k) funds. For most people, this involves something called a rollover.

You may choose to roll over your money into an IRA, which you can open yourself at many different financial institutions, and these accounts can provide you with more investment options than a typical traditional 401(k) plan. Or you may simply choose to combine your money in another 401(k) account at your new job.

Whatever you choose, be sure to invest your money somewhere it can continue to grow and help you best reach your financial goals.

The difference between a 401(k) and a Roth 401(k)

Now that you know the basics of how a 401(k) plan works, there is one more important element to understand: the difference between a traditional and Roth 401(k).

A Roth 401(k) plan is not totally dissimilar from a Roth IRA as far as its potential tax benefits and the way it works. Like Roth IRAs, a Roth 401(k) is funded with after-tax contributions. That means your contributions will be taxed at your current tax rate, but when you make withdrawals in retirement they will be tax-free. The earnings that build in your Roth 401(k) will also be available to you tax-free.

For those who believe that taxes will generally be higher in the future, a Roth plan could be a good choice. If you prefer to put off paying taxes until retirement, a traditional 401(k) plan is the better account for you.

Not all employers will provide the option for a Roth 401(k) plan, so if you are unsure what your company offers, be sure to speak with someone in your human resources department or your plan sponsor.

Bottom line

401(k) plans can vary quite a bit based on the company you work for. But the most important thing when it comes to retirement planning is to contribute as much as you can every single year. If your employer offers a match program, consider taking full advantage of the offer. And if you’re still left wondering whether you’re doing enough to save for retirement, consider speaking to a financial professional so you can be sure to avoid any costly retirement mistakes.

Betterment Benefits

  • Transfer your 401k or IRA in as little as 60 seconds
  • Personalized portfolio to meet your optimal level of risk
  • Access to a team of financial experts
  • Save your savings from high fees