What is a 401k?

Disclaimer: We are reader supported.  We may be compensated from the links in this post, if you use products or services based on our expert recommendations. Please read our Advertising Disclosure.

There is a huge variety of retirement saving plans but one of the most popular options is a 401(k) plan. This plan was introduced in 1978.

It is important to understand the basics of investing in a 401(k) plan if you want to take complete advantage of this employer-sponsored retirement plan.

What is a 401(k) Retirement Savings Plan?


It is, as explained earlier, a retirement savings plan that is employer-sponsored. It helps you plan for your retirement along with serious tax benefits.

When you opt for a 401(k) plan, you set up a percentage of your income to be invested in this account. This amount is automatically cut from each paycheck.

Participants have the freedom to allocate the funds in this investment account as per the options offered in the plan. These options typically include a wide range of mutual funds.

The Several Types of Employer-Sponsored Retirement Plans


Many retirement plans are employer-sponsored such as traditional 401(k) 457(b), 403(b), and Roth 401(k).

Traditional 401(k)

This account is funded with pretax dollars. It helps in lowering your taxable income as the contribution amount is directly withdrawn from the paycheck before payment of any taxes.

Consider an example where your income is $90,000 in 2021 and your contribution to your 401(k) is $5000. It simply means that you will be taxed on an income of $85,000.

However, all the contributions and other earnings in this account are fully taxable when you eventually withdraw money from this account at retirement. The rate of taxation will be the rate applicable at the time of withdrawal.

Roth 401(k)

The major difference in this type of retirement savings plan is that the account is funded with after-tax dollars.

It simply means that once you start withdrawing money from this account after retiring at the age of 59.5 or a later date, this income will not be considered taxable income. However, it does not include the employer match as it gets taxed when it’s collected.

As far as choosing between these two options is concerned, it depends on the prices offered by your employer as well as personal preferences.

In case your company offers only 401(k) plans, it might be possible for you to invest in both of these types of plans. Get in touch with the administrator at your company to know more.

Other Retirement Savings Plans

There are certain types of jobs such as a job in a nonprofit, tax-exempt organization, religious organization, state college, or public school, where the employees have other options such as a 403(b) plan.

Some other types of jobs such as a state government job or a local government job including a police officer or teacher also offer the option of investing in a 457(b) plan.

These retirement savings plans are similar to 401(k) savings plans in terms of available investments and contribution limits.

Difference Between 401(k) and IRA


The biggest difference between an IRA and 401(k) is that 401(k) is offered by the employer but an IRA or individual retirement account is opened by an individual on their own.

IRAs do not have the same benefits as 401(k) such as a higher contribution limit or employer match but they have other advantages such as more investment choices and flexibility.

It is possible to make contributions to both the employer plan as well as a Roth IRA or traditional IRA but it depends on the income level.

Employer Matching for Retirement


Employer match is what the term implies. It simply means that the employer matches the contribution of the individual’s contribution to their 401(k) up to a particular limit.

Companies offering employer matches determine the amount of contribution based on a percentage of the employee contribution. 

Let us consider an example. A company may choose to contribute 50% of the first 8% of the employer contribution.

If the annual salary of an employee is $80,000 and their contribution is 8% to the 401(k), the employee contribution will be $6400 and the employer contribution will be 50% of that which means $3200.

It is up to the employee to contribute more but the employer contribution will be limited to $3200.

Vesting


Most employers have a particular vesting period after which all the employer contributions belong to the employee.

All the contributions made by you to your 401(k) plan are yours to keep but you need to understand that the employer matching is not your money immediately.

In most cases, most employers have a condition that the employee needs to work with them for a period of 3 to 5 years before they are 100% entitled to the employer match.

In case an employee decides to leave a company only after 2 years but the original vesting period mentioned by the company is 3 years, it simply means that the employer contribution to the 401(k) of that employee will go back to them.

It is also possible that the employee receives only a part of the employer contribution as per the vesting schedule of the company.

Contribution Limits – 401(k)


There are contribution limits. For the year 2022, employees have a maximum contribution limit of $20,500.

This is a pretax contribution limit or Roth deferral. Employees above the age of 50 are allowed to make an additional contribution of $6500 to their 401(k).

It simply means that individuals above the age of 50 are allowed to contribute up to $27,000 each year. As far as the maximum contribution limit to a Roth IRA or an IRA is concerned, it is $6000 per year. This limit is $7000 for employees above the age of 50.

Withdrawal Rules for a 401(k)


  • Withdrawing Early

In most cases, individuals are not allowed to make withdrawals from their 401(k) when they are still employed and below the age of 59.5 but there are exceptions when an individual can request a hardship withdrawal.

These include:

  • Funeral or medical expenses related to you or for the family
  • Post-secondary tuition fee for family or you
  • Buying or repairing damages to the primary residence
  • Contribution towards preventing immediate eviction or foreclosure of the primary residence

A hardship withdrawal of pretax contributions is taxable and there may also be a 10% penalty for early withdrawal. Keep in mind that hardship withdrawals are not allowed to be rolled over into an IRA.

  • Taking Loans

Taking a loan on the 401(k) is also an option. In most cases, individuals are allowed to withdraw lesser than $50,000 or 50% of the total fund amount. However, the employees have to repay this loan along with interest within 5 years.

There are no penalties or taxes and all the interest money is also credited into the account. But there are exceptions.

If an employee leaves their current job while they have taken a loan, they or may be asked to pay back the loan in full within a particular time.  

If the employee defaults on the loan, they are required to pay taxes along with a 10% penalty in case they leave their current job before turning 55.

  • Withdrawals for Retirement

Employees are allowed to withdraw from their 401(k) account when they reach the age of 55 if they leave their employer in the year they turn 55 or more.

If the employee decides to leave their employer before turning 55, they will have to pay a 10% premature distribution penalty until they reach the age of 59.5.

However, you should also know that employees are not allowed to keep their money in the 401(k) forever.

The money can remain in a 401(k) up to the age of 72 and once an employee reaches that age, they have to start taking distributions from this retirement account.

  • Job Change

When an employee changes jobs, they are no longer eligible to make contributions to the earlier employer’s retirement savings plan.

If you are planning to change jobs and have no plan to retire, there are a few alternatives to what you can do with the money in your 401(k).

  • Keep the Money

If you decide to change jobs, you will not be able to contribute to the 401(k) plan but some companies allow their employees to keep their 401(k) active in case it has a particular vested balance. In most cases, this balance is typically more than $5000. 

Transfer the balance to the current employer — If you decide to choose this option, you will not have to pay any tax penalties and you will be allowed to continue investing in a new plan.

  • IRA Rollover

This option allows you to invest in various assets that are typically not offered through a 401(k). On top of that, there are no tax penalties.

IRA does not allow automatic contributions but it also gives you more flexibility to keep all the money in one place. This option comes especially handy when one has multiple 401(k) plans due to continuous job changes.

Before switching to IRA, it is important to seriously consider all the pros and cons of an IRA rollover.

  • Cashing Out

You also have the option of cashing out with a lump sum distribution but it will attract tax along with a 10% penalty in case you have left your current job before turning 55 and your age is still below 59.5.

In short, it will cost you big time in case you decide to make a withdrawal.