Since its inception in 1978, the 401(k) plan has become the most popular type of employer-sponsored retirement plan in America. Millions of workers depend on the money they invest in these plans to provide for them in their retirement years. For many, it's a key benefit of the job.
Few other plans can match the relative flexibility of the 401(k). Sure, there are rules to follow, but that's because you're getting tax breaks from the federal government in return for investing for retirement.
Key Takeaways
- A 401(k) is a qualified retirement plan, meaning it is eligible for special tax benefits.
- You can invest a portion of your salary up to an annual limit.
- Your employer may or may not match part of your contribution.
- The money will be invested for your retirement, usually in your choice of several mutual funds.
- With a few exceptions, you can't withdraw money without paying a tax penalty until you're 59½.
What Is a 401(k) Plan?
A 401(k) plan is a retirement savings account that allows an employee to divert a portion of each paycheck into long-term investments. The employer may match part of the employee's contribution as a job benefit. A 401(k) is technically a qualified retirement plan, meaning it is eligible for special tax treatment under Internal Revenue Service (IRS) guidelines.
Defined Contribution Vs. Defined Benefit
Qualified retirement plans come in two versions: defined contribution plans and defined benefit plans, such as a pension. The 401(k) plan is a defined contribution plan, which means the employee manages the fund and chooses the investments. When the employee retires, the account balance is theirs to use as they see fit.
In a traditional 401(k) plan, the money that the employee pays into the 401(k) is tax-deferred. No income taxes will be due until the money is withdrawn. The earnings are not taxed until they're used either.
The Roth 401(k) Variation
Not all employers offer it, but the Roth 401(k) is an increasingly popular variation of the traditional 401(k) plan. If you have a Roth plan, you'll pay income taxes on the money you pay into your fund. When you withdraw it after you retire, no further taxes will be due on the principal or the earnings. Employer contributions can only go into a traditional 401(k) account—not a Roth.
401(k) Contribution Limits
The maximum amount of salary that an employee can defer to a 401(k) plan, whether traditional or Roth, is $23,000 for 2024. Employees aged 50 and older can make additional catch-up contributions of up to $7,500. The IRS also limits the maximum joint contribution by both employer and employee to $66,000 in 2024, or $73,500 for those over 50.
401(k) Investment Options
A company that offers a 401(k) plan typically offers employees a choice of several investment options, usually managed by a financial services advisory group such as The Vanguard Group or Fidelity Investments. The options are usually mutual funds, and they may include index funds, large-cap and small-cap funds, foreign funds, real estate funds, and bond funds. You can adjust your investing strategy from time to time, moving your money to more aggressive or more conservative choices.
Rules for Withdrawing Money
The distribution rules for 401(k) plans differ from those that apply to individual retirement accounts (IRAs). In either case, an early withdrawal of assets will mean income taxes are due, and with few exceptions, a 10% additional tax penalty will be levied on those younger than 59½.
Triggering Events
A triggering event must be satisfied to receive a payout from a 401(k) plan. The usual triggering events include:
- The employee retires or leaves the job.
- The employee dies or is disabled.
- The employee reaches age 59½.
- The employee experiences a specific hardship as defined under the plan.
- The plan is terminated.
Post-Retirement Rules
Account owners who turned 73 on or after Jan. 1, 2023, must begin taking required minimum distributions (RMDs) at age 73 unless they still work for the sponsoring employer and have a plan that allows them to defer RMDs. The age for RMDs has been raised a couple of times in the past, and may well be raised again.
The Rollover Option
Retirees may choose to transfer the balance of their 401(k) plans to a traditional IRA or a Roth IRA. This rollover gets them access to a broader array of investment choices than employers usually offer for 401(k) accounts. A direct rollover avoids tax implications, while an indirect rollover requires taxes to be paid on the balance in that tax year.
401(k) Plan Loans
If your employer permits it, you may be able to take a loan from your 401(k) plan. If this option is allowed, up to 50% of the vested balance can be borrowed up to a limit of $50,000. The borrower must repay the loan within five years. Should you leave your employer, you will be required to pay any pending 401(k) loan balance in full or face IRS tax or penalties.
Hardship Distributions
Emergencies happen, and you may find that the only place you can turn to meet your immediate financial needs is your retirement plan. While it may not necessarily be the best route, you have the option to take a hardship distribution or withdrawal.
401(k) Strategies
No single retirement strategy is best for everyone, but there are tips that benefit most investors:
Maximize Employer Match
Contribute at least enough money to take full advantage of your employer match. This strategy maximizes the free money you receive from your employer.
Be Mindful of Contribution Limits
The IRS does not permit contributions that exceed its annual 401(k) limits. Should you overcontribute, you are required to withdraw those excess contributions, triggering taxes and penalties.
Compare Roth and Traditional 401(k) Benefits
In general, it is better to contribute to a Roth account if your tax bracket is currently low and you expect to be higher in the future. A traditional account is preferable when your tax bracket is currently high.
Avoid Early Withdrawals
Early withdrawals are subject to federal income tax plus a 10% penalty, and they also damage the compounding effect of your investments.
Conclusion
Saving for retirement should be on your radar if you hope to maintain your current lifestyle. The best place to start is the 401(k) plan offered by your employer. Take full advantage of it, especially if your employer matches contributions. Knowing the ins and outs and the rules associated with the plan can make you a better investor.
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