A 401(k) plan is one of the most common retirement savings options for Americans who work in the for-profit sector. If your employer offers one—or if you work for yourself—you stand to enjoy far greater financial security by learning the ins and outs of how 401(k)s work and understanding why it's generally a good idea to contribute if you're eligible.
What is a 401(k)?
A 401(k) is a type of defined contribution plan. It's named after the section of the Internal Revenue Code that lays out the laws for these plans and states how much money you can put into one. If you're trying to find tax information about 401(k) plans from the IRS, however, it's important to know that they're also called
Other popular types of retirement savings accounts, such as
By contrast, a pension is a type of defined benefit plan. These plans' rules predetermine how much you'll get out of them.
Social Security retirement benefits are only meant to meet your basic needs and keep you out of poverty. Learning about your retirement savings options and how to make the most of them helps you stay proactive about the future, wherever you are in your financial journey.
Who is eligible for a 401(k)?
You can contribute to a 401(k) plan if your employer offers one and if you meet your employer's eligibility requirements. A federal law called the
The documents you received when you accepted your job should explain the benefits your company provides, including a retirement savings plan. If you're unsure, ask your coworkers, your boss or your human resources department. If your company has an online employee benefits center, you may be able to get the information you need by logging in.
Every company that has a 401(k) plan is responsible for offering a formal document called a summary plan description detailing the plan's rules, including who is eligible to contribute. Save a copy of this document to reference later.
One common eligibility requirement involves working for the company for a certain amount of time. If you're a full-time employee, you could have to work there for six months before you're allowed to contribute or receive an employer match. If you're a part-time employee, you may have to work an average of 20 hours per week or another minimum to be eligible.
How does a 401(k) work?
Among the range of 401(k)s, traditional 401(k) contributions are the most common. These plans accumulate pretax dollars through payroll deductions during your working years. In retirement, you can withdraw the money you put in, along with any investment earnings. This is called taking a distribution, and traditional distributions are taxable.
You can also contribute after-tax dollars to the plan using
If you make both types of contributions, they'll be held within the same account (unlike traditional and Roth IRA contributions, which are held in separate accounts).
Types of 401(k) plans
Aside from the standard 401(k), the IRS allows for some variations suited to specific needs.
If you are a business owner and have no employees, you can contribute to a
Benefits of 401(k) plans
If you're eligible for an employer-offered 401(k), here's why it pays to participate.
Many employers match a portion of your contributions via employee matching contributions, and some may even contribute money to your 401(k) whether you do or not in what are called nonelective contributions. To get the most out of your plan, get to know your employer's matching policy.
Let's say you make $100,000 and your employer offers a 5% match. If you have 5% of your pay ($5,000) withheld from your paycheck and put into your 401(k), your employer may also put $5,000 in your account. You'd then have a total of $10,000, which means you're effectively saving 10% of your salary for retirement. That's like getting 100% return on your investment. Plus, you won't owe Social Security, Medicare or FICA taxes on your employer's contributions.
Whether you choose Roth or traditional contributions, employer contributions are traditional.
Even if your employer doesn't contribute to your 401(k), you can still reap the rewards of contributing yourself; your investment earnings grow tax deferred. Say your account value increases from $1,000 to $1,100 from January 1 to December 31—the $100 increase is not taxable. If you experienced the same gain in a nonretirement account, it would be taxable.
Tax-deferred growth helps your account balance grow far larger than the same contributions could in a taxable account. Suppose you invested $300 a month and earned returns of 6% per year. If you put that money in a 401(k), you'd have $138,851 after 20 years. If you put that money in a taxable brokerage account, you'd only have $115,212—$23,639 less—assuming your federal marginal tax rate was 22%.
Whichever type of 401(k) you contribute to and whichever type of contributions you make, tax-deferred growth can help you generate more money for retirement.
Generous contribution limits
401(k) plans have higher annual contribution limits compared with IRAs. For 2022, an employee can contribute up to $20,500 of their salary to a 401(k). An employer can contribute even more, for a total possible contribution of up to 100% of your salary or $61,000 (2022 limit), whichever is lower. If you're 50 or older, you can contribute up to $6,500 more for a total of $67,500.
The most you can contribute to an IRA in 2022 is $6,000 ($7,000 if you're 50 or older). Depending on your modified adjusted gross income, or MAGI, in addition to contributing up to the limit in your 401(k) you can also contribute to a Roth IRA each year. If you choose to contribute to a Traditional IRA instead of a Roth IRA, MAGI limits would apply to the deductibility of the contribution.
If you can afford to do so, it's a good idea to
Near the end of each year, the IRS announces the retirement account contribution limits for the coming year. Sometimes, they stay the same; sometimes, they rise, depending on inflation. However, 401(k) limits are typically far higher than IRA limits.
If your employer doesn't offer a 401(k), it's even more important to
Drawbacks of 401(k) plans
Before you contribute to your 401(k), keep in mind that there are reasons to be careful about how much you put in.
Once you contribute money to a 401(k), it can be difficult to get that money back before you reach age 55 or age 59½. Some plans include options to
Some plans allow you to take a type of early distribution called a hardship withdrawal under specific circumstances, such as having high medical expenses or needing to repair certain types of damage to your home. However, these distributions may require you to pay a 10%
Further, you might be surprised at how many kinds of financial emergencies don't count as a hardship. For example, the IRS doesn't classify a temporary short- or long-term disability as a hardship, even though disability typically means you're earning less and incurring more medical bills. This is one of many reasons that
Given these restrictions on withdrawing money before you're 59½, it's important to find that sweet spot—contributing enough to meet your retirement goals but not so much that you'll have problems meeting your expenses before retiring.
Once you make a contribution, you may be limited to a preselected menu of investment options. In 2020, the average plan offered
For many people, not having to choose from the entire pool of investments the market offers can be a good thing. More experienced investors may prefer to have more options.
Once you reach age 72, IRS rules generally require you to start taking money out of your 401(k) through
Some people don't like RMDs because they may not need to withdraw as much to cover their expenses as the IRS requires. They'd prefer to keep the money in the account where it can continue to grow tax-deferred.
How to contribute to your 401(k)
If you've been enrolled automatically, you'll see the deductions on your pay stub. However, you may want to change your contribution rate or how your money is invested. You can do this by logging into your account through your plan administrator's website. You can also use the website to characterize your contributions as traditional or Roth and determine what percentage of your paycheck goes to each type of contribution.
If you're not already enrolled, you can begin at any point during the year as long as the employer allows and you're eligible to participate. Ask your company's human resources department how to sign up. Then, create your account on the plan administrator's website so that you can easily manage your contributions and investments.
How to withdraw money from your 401(k)
To take a distribution, contact your plan administrator—the financial services company whose name is on your account statements. You can make your request online, by phone or by mail.
Each plan has requirements that must be met in order to allow a distribution to be sent directly to you. If your request is approved, they'll send you the money by check or direct deposit. If applicable, they will
You must meet specific requirements to take distributions. The requirements will depend on what the plan document allows, the type of distribution you're taking (e.g., RMD, hardship, loan) and whether you still work for your employer (these are called "in-service distributions") or not. Consult your summary plan description for details.
Putting your 401(k) knowledge to use
A 401(k) helps you build a foundation to shape your retirement as you'd like it. Are you ready to contribute or unsure what your next move should be?