How Does a 401k Work?

A 401(k) is a popular retirement savings plan that employers often offer their employees in the United States. It gets its name from the section of the Internal Revenue Code that governs these types of plans. A 401(k) plan provides a tax-advantaged method to save and invest for your retirement.

In a 401(k) plan, you can contribute a portion of your pre- or post-tax income into an individual account. The contributions may be deducted from your taxable income, which means you can potentially lower your overall tax liability. 

The funds you contribute to your 401(k) account can then be invested in various options such as mutual funds, target-date funds, stocks, bonds, and company stock.

How do 401(k) plans work?

401(k) plans are designed with Americans' retirement in mind. Congress created them to give you the opportunity to invest a portion of your earnings towards your future, so you can potentially draw some income even if you can no longer work. You can typically contribute to a new 401(k) plan when you join a company that offers them.

Your employer may have eligibility requirements you must meet before you make contributions, such as a pre-set length of service with the company. Once eligible, you may be able to choose between two 401(k) plans, Roth or traditional. 

Roth 401(k)s work well for anyone who wants to pay taxes before contributing. More companies are now offering them, giving you more ways to approach retirement. The best part of a Roth 401(k) is that you won't have to pay anything in taxes when you withdraw your money during retirement. 

Traditional 401(k)s work differently because you make your contributions pre-tax. This is beneficial for anyone looking for a tax-break upfront, lowering their current income tax bill. Another key benefit of investing pre-tax dollars is the increased exposure to the market through a larger investment. $15 pre-taxed dollars is still $15 once you contribute it, whereas $15 taxed at 33% leaves you with just $10 to contribute. This can impact your overall investment balance long-term. Traditional 401(k) contributions are made pre-tax, so you must pay taxes once you withdraw funds. 

No matter which type of 401(k) you select, fees could be assessed on an early withdrawal. It's always good to consult with a financial adviser if you want to withdraw from your 401(k) but you're unsure if there are fees for doing so. 

Contribution limits

The Internal Revenue Service has set limits on what you as an employee can contribute to your 401(k) plan. As of 2023, the maximum you can contribute to your traditional or Roth 401(k) plan is $22,500, up from $20,500 in 2022.

If you're 50 or older, you can contribute an additional $7,500 to your plan, up from $6,500 in 2022. These additional contributions are often referred to as "catch-up contributions." 

Companies often offer a matching program where they contribute towards their employees' retirement accounts based on several factors. The IRS also has a limit for their contributions, setting a combined maximum of $66,000 for employee and employer contributions. This does not include catch-up contributions.

Who invests your money in a 401(k)?

In a 401(k) plan, the responsibility for investing the money employees contribute lies with the plan participants themselves. It is your 401(k), so you are the plan participant and make decisions regarding the allocation of your contributions among the investment options provided by the plan.

The plan sponsor, typically the employer, is important in facilitating the 401(k) plan. The plan sponsor is responsible for establishing and maintaining the plan, ensuring it complies with legal and regulatory requirements, and providing certain administrative functions.

The plan sponsor selects a plan provider to handle the day-to-day operations and services of the 401(k) plan. The plan provider can be a financial institution, such as a bank or investment firm, or a specialized retirement plan service provider. The plan provider assists with various aspects of the plan, including recordkeeping, investment management, participant communication, and compliance.

The plan sponsor also has a fiduciary duty to act in your best interests. This means the employer has a legal responsibility to prudently select and monitor the plan provider, ensuring that the services offered are in the best interests of the plan participants.

The responsibility for investment decisions is yours. In a 401(k) plan, you have the autonomy to choose your investment options and adjust your allocations based on your risk tolerance, investment goals, and time horizon. The plan sponsor and provider are responsible for supplying the necessary tools, information, and support to assist you in making sound investment decisions.

Employer matching

Many employers offer 401(k) matching to incentivize their employees to save for retirement and as a benefit of working for them. Most employers have a preset matching schedule, where they may contribute a certain amount to your plan based on your contributions, up to a certain amount. 

This usually comes as a matching percentage, where your employer matches a predetermined percentage of your contribution. If your employer matches 50% of your contribution and you contribute $1,000, that equates to an additional $500 in your 401(k). 

Employers often set a limit on the amount they may match. This limit is usually a percentage of your salary or a specific dollar amount. For instance, an employer may match 50% of your contributions up to a maximum of 4% of your salary. If you contribute more than the matching limit, the employer can only match up to the specified limit.

Vesting refers to the ownership of employer-matching contributions. Employers may impose a vesting schedule, which determines how long you must remain with the company before you are entitled to the employer's matching contributions. 

Vesting schedules can vary, but they typically have either a graded or a cliff vesting schedule. With graded vesting, your ownership of the matching contributions gradually increases over time. With cliff vesting, you become fully vested after a certain number of years of service.

Leaving your job with a 401(k)

When you leave your job where you had a 401(k) plan, either traditional or Roth, you have a couple of options. Some companies may let you leave your funds in your current 401(k), where they may manage your plan for free. Conversely, other companies may let you leave your current 401(k) with them but may charge an administrative fee for their involvement. You won't be able to make any more contributions to your old plan, but you should be able to access them in a web portal or through regularly mailed paperwork.

You may also roll over your previous employer's 401(k) plan to your new employer's. Before doing so, check if any fees are involved and if your new workplace offers the same investment options. 

If you urgently need the funds in your 401(k), you can withdraw them but may be assessed a 10% early withdrawal penalty if you're below the age of 59 1/2. 

No matter what you want to do with your old 401(k), talking with a plan administrator to get a clear idea of your options is important. 

Withdrawing from your 401(k)

Most people begin withdrawing from their 401(k)s when they reach retirement age or meet the qualifying circumstances. If you have a Roth 401(k), you've already paid taxes on your contributions  and can withdraw them without paying taxes again. However, your earnings are subject to a holding period in which you must keep your contributions in a Roth 401(k) for five years to avoid tax on any associated earnings

If you have a traditional 401(k), you must pay taxes on anything you withdraw as ordinary income.

Both Roth and traditional 401(k) owners must be at least 59 1/2 years old to qualify for penalty-free distributions from their retirement accounts or meet other criteria put forward by the IRS. As the IRS states, the penalty for early distributions is usually 10% of the amount withdrawn. 

Required minimum distributions

After reaching 73 years old, if you are a traditional 401(k) owner, you must begin taking required minimum distributions (unless you are still working for the company). The maximum age has steadily increased over the last few years, starting at 70 1/2 in 2020 and rising to 72 in 2022 and 73 in 2023. In 2033, the maximum age will increase yet again to 75.

The amount the IRS requires you to withdraw depends on your age and life expectancy. The IRS created RMDs to ensure you can't grow your investments in a tax-advantaged account forever.

If you don't take your RMDs when you reach 73, there is a staggering 25% penalty on any missed distributions from your 401(k) plan. 

You are the sole selector behind your 401(k) plan investments. Most companies offer their employees stocks, bonds, mutual funds, target-date funds, exchange-traded funds, and sometimes company stock to fill their 401(k)s. You can learn more about the age you can retire and savings options by getting in touch with a financial adviser.

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