What Is a 401(k) and How Does It Work?

Still trying to figure out what a 401(k) plan is and how it works? Discover the answer to this question and more in this detailed guide.

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By Entrepreneur Staff

Disclaimer: This article is for informational purposes only. It should not be considered legal or financial advice. You should consult with an attorney or other financial professional to determine what may be best for your individual needs.

Every American has to plan for retirement if they want to enjoy their golden years. But that's easier said than done, especially if you try to save up all the money you need for 10, 20 or even 30 years of life after you stop working 40 hours a week.

That's where 401(k) plans come in. 401(k)s are some of the most popular retirement plans available to Americans in most major industries and professions.

This article will examine what 401(k)s are, how they work and whether you should sign up and contribute to a 401(k) for your retirement goals.

Related: 2022 Retirement Planning: The New Rules Explained

What is a 401(k) plan?

A 401(k) is a type of retirement plan that combines individual contributions from you, the future retiree and your employer.

As a result, 401(k) retirement savings plans allow you to accumulate more savings than many other plans. This is partially why 401(k)s are so popular among average Americans.

401(k) plans derive their rules from the U.S. Internal Revenue Code or IRC. More specifically, a 401(k) plan requires:

  • An employee to automatically put a percentage of every paycheck into a retirement investment account.
  • An employer to contribute the same amount or a percentage of money into the same retirement investment account.

Depending on the 401(k) plan you choose, you may be able to pick different investment options, though most rely on investing in mutual funds. Mutual funds are essentially collections of stocks and other tradable assets. Management firms run them.

Because mutual funds diversify risk by keeping money in many different assets or instruments, they are more resilient against market downturns, recessions and other adverse economic activity. This way, 401(k) plans are among the safest retirement options for most Americans.

Related: Are We in a Recession? Here's What Economists Say

Why do people use 401(k)s?

Most people use 401(k) plans because they are simple, convenient and easy to "set and forget."

For example, you can sign up for a 401(k) plan through your employer and agree to contribute 3% of each paycheck to your retirement account.

At the same time, your employer agrees to match contributions up to 3%. You'll pay for 3%, but due to matching, 6% funnels into your retirement account. Company matchplans work to incentivize higher annual contributions and can help bring you more investment earnings.

On top of that, 401(k) plans don't require employees to stress over their investments. As noted earlier, most 401(k) retirement accounts invest money in safe mutual funds that are predicted to grow slowly but steadily over decades.

Since a 401(k) account produces significant long-term returns to guarantee retirement-age security, this is not a downside.

In contrast, most other retirement investment plans, like individual retirement accounts or IRAs, require you to have a much more active role in how much you invest each month, where you put your money, etc.

Related: Small Businesses and Independent Contractors Can (and Should) Financially Prepare Themselves for the Future

Is a 401(k) plan the only kind of retirement plan?

No. There are IRAs, individual stock investing and other plans. However, 401(k) plans are convenient and can often be an excellent choice for Americans interested in saving for retirement.

How does a 401(k) work?

Imagine that your monthly paycheck is $3,000. Each month, you get 3% of that paycheck deducted and put into your 401(k) retirement investment account. 3% of $3,000 is $90.

If your employer matches that contribution amount, your retirement account will gain $180 monthly, slowly building up wealth.

Where does that money go? Depending on the 401(k) retirement account, most of it will be invested into various mutual funds. Mutual funds are selected for their safety and financial security.

They are usually selected to grow steadily in value over several decades rather than grow massively over a few months or years.

When the time comes for you to withdraw money from your retirement account, you can either withdraw your entire 401(k) balance or a percentage of each month or year. The remainder of your 401(k) account continues to accrue value in the latter option.

How do 401(k)s earn money?

401(k)s earn money like all stock and financial asset investments earn money. For example, if you invest in a stock for a specific company, like Apple, by purchasing a share for $300, and that share rises in value to $500 over two years, you can sell the share for a $200 profit.

401(k)s do the same thing, albeit in a slightly more complicated way. As you contribute money into your 401(k), the 401(k)'s account manager has more money to invest in worthwhile assets or mutual funds.

The more money you contribute, the more money you make. Let's return to the example above: If you invested early in Apple, such as when shares were below $100 each, you would be pretty wealthy now if you had purchased more shares earlier now that they are worth much more.

Related: The Basics of 401(k) Financing

Contribution limits for 401(k)s

Note that 401(k) investment accounts do have some contribution limits to keep in mind. 401(k) plan contribution limits, the maximum amount that employees can contribute to their plan, are adjusted annually to account for economic inflation. For instance, in 2022, the contribution limit was $20,500; after an inflationary year, the limit was lifted to $22,500 for 2023.

Maximum contributions prevent plan participants from investing all extra cash into their retirement fund. However, you can put that money into other retirement funds, like IRAs (which have their own contribution limits).

In 2022, for instance, the contribution limit was $20,500 per year for all workers under 50. Those over 50 could contribute up to $6,500 extra to "catch up" to their retirement goals.

2023 will see annual employee contribution limits of $22,500 per year for workers under 50. The catch-up limit for workers over 50 will be $7,500. Catch-up contributions aren't the same as rollover funds, funds which you move from one eligible retirement plan to another and typically aren't available to 401(k)s.

Types of 401(k) plans

There are two types of 401(k) plans an employer may offer (you don't get to choose in most cases, though some employers allow you to pick between them). Here's a breakdown of the two types of 401(k) plans and their differences.

Traditional 401(k)s

A traditional 401(k) is similar to a conventional IRA in that your contributions are deducted from your gross income. In other words, the money comes from your payroll before income taxes have been taken away.

What does this mean in the long term? For one, you can deduct your 401(k) contributions since those contributions aren't part of your pre-taxtaxable income.

For another, you'll have to pay taxes on those contributions later when you withdraw money from your 401(k) account. That money isn't tax-deductible forever.

Tax-deferred traditional 401(k)s can be advantageous if you don't think you'll be in a much higher tax bracket when you retire. Then, when you withdraw money from your 401(k), you'll just pay taxes on however much you withdraw at around the same tax bracket you are in currently.

Most 401(k)s are traditional for their tax benefits and wealth of investment choices. However, your employer's plan might be different.

Roth 401(k)s

Roth 401(k)s are the opposite: They have you pay taxes on your contributions as you make them, so you do not deduct those contributions from your gross income. It's not the same thing as tax-free.

This costs you more in the short term, but it could save you more in the long term. With an after-tax Roth account, you don't have to pay taxes on any money you withdraw.

Therefore, when you retire in a higher tax bracket, you won't pay even more to dip into your savings. Everything in your Roth account is after-tax dollars instead of the pre-tax basis that traditional 401(k)s reflect.

Both types of 401(k) accounts can be advantageous. You just have to decide whether you would rather pay taxes on your 401(k) contributions now or pay taxes on those contributions when you withdraw them later down the road.

Speak to a financial advisor about the tax advantages of both approaches (and whether tax deferrals are wise for you in general). They can also give you more information about employer-sponsored retirement plans, required minimum distributions, and early withdrawal penalties.

Related: Pros and Cons to Choosing a Roth 401(k) Over Traditional 401(k) — and Vice Versa

Can you withdraw money from a 401(k)?

Yes. However, 401(k) contributions and any earnings you make from those investments are meant to be withdrawn after you retire, not used as ordinary income.

Because of this, you'll have to pay a 10%early distribution tax – plus other taxes if you have a traditional 401(k) – if you withdraw any of your money from your account before you are 59.5 years old.

The IRS also has some additional criteria that may allow you to withdraw money from your 401(k) account before reaching the stage, such as being permanently disabled.

Generally, it's advisable to avoid withdrawing money from your 401(k) until you retire by any means necessary.

What if you leave your job?

Fortunately, your 401(k) plan does not disappear when you leave your employer. Many – if not most – companies allow you to transfer your 401(k) plan if you switch jobs.

However, switching employers does mean that you may have a slightly different 401(k) plan and rules to follow. For instance, one employer may match your contributions up to 3%, while another may only match your contributions up to 2%.

You should carefully read the fine print when deciding to switch employers because it can impact your retirement plan.

You can also continue contributing to your 401(k) account even if you switch to a new employer or stop working for employers that offer 401(k) matching entirely.

How to start contributing to a 401(k) plan

The best way to start contributing to a 401(k) plan is to become employed with an employer that offers 401(k) matching. Employer contributions are, by far, the most significant benefit of using a 401(k) plan for your retirement.

When you sit for a job interview, ask about retirement options. Most companies should be easily able to explain what they offer in terms of 401(k) plans, contribution matching policies, etc.

Once you start working for a company that offers 401(k) contributions, sign up for automatic 401(k) deductions.

That way, you don't have to worry about saving for your retirement; your 401(k) contributions will be deducted automatically from every paycheck you receive. Your employer-matched contributions will also kick in automatically without any further effort on your part.

Related: Searching for Talent? Consider Setting Up a 401(k) for Your Small Business to Keep Up in the Market.

Is a 401(k) right for everyone?

No. 401(k) plans might be unavailable for freelancers or those who own businesses. In such cases, you might be better off with an IRA or individual retirement account.

IRAs allow you to invest in mutual funds, exchange-traded funds or ETFs and other investment products that firms usually manage. Similar to 401(k)s, IRAs require you to contribute a certain amount into your account each month or year, and they have certain limits.

For instance, 2022's traditional IRAcontribution limit was $6,000 annually. Unlike a 401(k), no one matches your contributions, so you are entirely responsible for funding your retirement account.

On the plus side, you're also in control of where your investments go. You can tweak your IRA to target fast growth, slow growth, or something in between.

You can also pursue a Roth IRA, similar to a Roth 401(k): you pay taxes on your contributions immediately but don't have to pay taxes on withdrawals later.

Related: 4 Ways to Save for Retirement Without a 401(k)

What's the bottom line about 401(k)s?

Ultimately, a 401(k) plan could be the right method of saving if you want to reach your retirement goals on time and not sweat finances too much. 401(k) plans are advantageous for many Americans, so consider contributing to one if you haven't already.

That said, 401(k) plans are just one of the retirement options you can pursue. IRAs and other retirement plans might be better, depending on your circumstances.

Looking for more info to expand your financial and professional knowledge? Explore Entrepreneur's Money & Finance articles here.

Entrepreneur Staff

Entrepreneur Staff

Editor

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