Table of Contents
What is a 401(k) plan and how does it work?
Requirements for a 401(k) Plan
Traditional 401(k) vs. Roth 401(k)
Employer 401(k) matching contribution
FAQs about 401(k) plans
The bottom line
What Is a 401(k) Plan?
Feb 10, 2022
7 min read
A 401(k) is a retirement savings vehicle offered by many employers. It offers tax advantages and investment opportunities and has higher contribution limits than other retirement accounts.
When it comes to building adequate retirement savings, an employer-sponsored 401(k) plan can often be top of mind. These investable savings accounts provide many different benefits to employees who are looking to save for the future, including tax advantages and even matched contributions from employers.
But while 401(k) retirement plans can be an important part of a successful retirement savings strategy, they also have some limitations. For one—the money contributed to these accounts is meant to stay there until retirement, with few exceptions.
Here’s a look at what 401(k) plans offer, how much individuals can save in these accounts each year, and when the funds will be available for use in retirement.
A 401(k) plan is a tax-deferred retirement savings vehicle offered by employers as a way to help employees save for their retirement. It allows employees to direct a portion of their earnings into the account and defer paying income tax on it until they withdraw it in retirement. Funds that are directed to a 401(k) can be invested in various securities, including mutual funds, exchange-traded funds (ETFs), stocks, bonds, options, and more.
Employees are offered a number of different investment options pre-selected by the employer, and any contributions made into the 401(k) account can then be invested into the funds chosen by the employee. Contributions are automatically deducted from employees’ paychecks, at whatever rate the employee selects.
With a traditional 401(k) plan, contributions are made with pretax dollars. Any qualifying funds contributed to a 401(k) plan throughout the year can be deducted, reducing one’s total taxable income for that year.
Employers may also choose to match some or all of their employees’ contributions to their 401(k), in what is known as an employer match.
When an employee leaves the company, they can choose to rollover their 401(k) funds into a new employer’s 401(k) or into an individual retirement account (IRA).
For 2022, individuals can contribute up to $20,500 into a 401(k) savings account. (This is a jump from the $19,500 contribution limit for 2021 and 2020.) Those age 50 or older can make additional catch-up contributions to their 401(k), for an extra $6,500 per year. This brings the total allowed contribution to $27,000 per year for 401(k) plan employees 50 or older.
Qualifying individuals can also contribute to other retirement savings accounts, such as individual retirement accounts (IRAs), while they contribute to their 401(k) plan.
Funds invested in a 401(k) savings plan can be withdrawn for retirement expenses beginning at age 59½. As long as an individual waits to take distributions until this time, they will avoid the early withdrawal fee of 10%, in addition to triggering a taxable event.
Certain circumstances allow for penalty-free early withdrawals. For instance, 401(k) plans may allow for loans, depending on the plan sponsor. These loans are limited to the lesser of $50,000 or 50% of the plan’s vested value. As long as the loan is repaid per IRS guidelines, there will be no penalty.
Some situations can qualify for early withdrawal, depending on the employer and the hardship. These might include medical expenses, tuition, costs related to buying a primary home, and funeral expenses for an immediate family member.
Account owners are also required to begin withdrawing from their 401(k) plan once they reach a certain retirement age. These 401(k) withdrawals, called required minimum distributions (RMDs), begin at age 72, and failure to take RMDs as scheduled will result in penalties on the amount not withdrawn.
The requirements for joining a workplace 401(k) plan depend on the employer and/or plan sponsor. Employers may require a worker to be with the company for a minimum amount of time before they can contribute to a company 401(k) savings plan.
Employees are often also required to be full-time employees, or to meet a minimum number of hours per year, in order to be eligible for 401(k) contributions. Employers can set minimum employee age requirements, only allowing those 21 and older to contribute to a plan.
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There are some important differences between traditional 401(k)s and Roth 401(k)s to note.
With a traditional 401(k), an individual makes contributions with pretax funds. The account holder contributes income that they deduct from their taxable income for the year; but once the account owner retires and begins withdrawing qualified funds, they pay ordinary income taxes on the money.
A Roth 401(k), on the other hand, is funded with after-tax dollars. These contributions are not tax-deductible, but will grow tax-free over the years. Account owners will not pay taxes on those gains when they begin taking distributions in retirement.
Another important difference involves early withdrawals. With a traditional 401(k), any early withdrawals (before age 59½) are subject to both income taxes and an early withdrawal penalty of 10%. Similar to a Roth IRA, however, Roth 401(k) contributions are not subject to penalty, even if they’re withdrawn ahead of schedule. Since Roth 401(k) contributions are made with after-tax dollars, there is no fee for withdrawing them early. However, if the gains on those contributions are withdrawn before the account owner turns 59½, those will be subject to penalties.
Some employers offer to match employees’ contributions into a sponsored 401(k) plan. This means that for every dollar the employee saves, the employer deposits a matching contribution. This can be dollar-for-dollar or a specific percentage (such as $0.50 for every dollar).
Employer matches are typically limited to a certain percent of the employee’s annual salary. For example, if an employee makes $60,000 per year and has a 3% match, that means the employer is willing to contribute up to $1,800 annually into the employee’s 401(k) account. In order to receive the full match, the employee must contribute at least $1,800 on their own.
Many employer 401(k) matching contribution plans are vested. Vesting refers to how long the employee must remain with the company if they want to keep all of the employer’s matched contributions. If the employee quits, gets fired, or otherwise leaves the company, they may leave behind some (or all) of the employer match that was added to their 401(k) account.
Let’s say an employer has a three-year vesting period. The employer matches $1,200 per year, contributing $2,400 to an employee’s account at the end of their second year of employment. However, the employee gets another job offer and leaves the company. Since they didn’t stay for the full three years, they will forfeit some or all of that $2,400.
If an individual changes jobs or otherwise leaves their workplace, they have a few options for their 401(k) savings.
into a traditional or Roth individual retirement account (IRA).
Some 401(k) plans allow for loans against the savings account. These loans are limited to the lesser of $50,000 or 50% of the plan’s vested value, and account owners may need to meet certain requirements in order to take out the loan.
A 401(k) plan loan will involve interest charges (which the account holder essentially pays themselves, since they are borrowing from themselves) and origination fees. Account owners will also be required to repay the loan within five years or the IRS will consider it a distribution. Those younger than 59½ will be subject to ordinary income taxes as well as a 10% early withdrawal penalty.
If an account owner borrows from a 401(k) plan and is fired or otherwise leaves their job, the former employer may require them to repay the loan immediately. Failure to do so may result in the loan being reported to the IRS as a distribution, subject to the same taxes and penalties.
A 401(k) is a retirement savings vehicle offered by many employers. It offers tax advantages and investment opportunities and has higher contribution limits than other retirement accounts such as IRAs. Both types of accounts allow account owners to access the savings as early as age 59½ without penalty.
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