What Is a 401(k)?

It’s always wise to get a head start on saving for retirement — it tends to arrive much quicker than you think. There are, of course, many routes you can take to accomplish this. But one of the most effective is a 401(k) plan.

Getting its name from the Internal Revenue Service (IRS) Code that governs it, a 401(k) is a long-term savings plan that lets you defer your paycheck or salary. Imagine a scenario where you could automatically save money from each paycheck you receive. In essence, that’s what you get with one.

With about 60 million Americans holding their money in them as of 2022, 401(k)s are one of the most common ways to save for the future. This article will explain how these plans work and outline pros and cons, including their unique tax advantages.

How 401(k)s Work

401(k)s allow you to automatically contribute a portion of your earnings into an account you open with your employer. As of 2024, you can allocate up to $23,000 (or $30,500 if you’re 50 or older) each year into your account. This number may fluctuate to keep pace with factors such as inflation.

You’ll be able to invest the money you’ve deferred. But it’s up to you to select investments from a specific set of options your employer has made available in your plan. This typically includes:

• Mutual funds
• Index funds
• Exchange-traded funds (ETFs)

Many employers match your contributions to a certain percentage. The exact amount varies by company, though. A common corporate matching structure is 100% of every dollar you set aside up to the first 6% each year. In other words, after you contribute 6% of your income, your employer won’t put in any more until the next year.

You can begin withdrawing funds from your 401(k) account as soon as you turn 59 and a half years old. It’s possible to access your money early; however, doing so will incur federal and state income tax (if applicable), as well as a 10% penalty. Once you reach the age of 73, the IRS will require you to begin taking money out of your account by way of required minimum distributions (RMDs).

Tax Advantages

401(k) plans come with significant tax benefits. However, the benefits you enjoy will be different depending on which plan you have. There are two types of accounts, traditional and Roth. Each has varying tax implications. And whether you have access to a Roth will depend on your employer.

Below is the difference between the two, as well as an explanation of their tax advantages:

Traditional 401(k)s

Traditional accounts deduct the money you put in from your taxable income. This means you don’t have to pay taxes on your contributions or gains until you begin distributing for retirement. At this point, the money you draw will count as taxable income. A certain amount comes off your paycheck before income tax, leaving tax payment for later.

A tax-deferred plan is advantageous because your pre-tax savings grow much more than they would if you were taxed before deduction. You’ll also pay a lower tax amount in the year you contribute to your account since your taxable income will be lower.

For example, let’s say you make $60,000 and set aside $6,000 (equal to 10% of your income) in your 401(k), reducing your taxable income to $54,000. You’ll pay fewer taxes in the current year than if you had kept the money or had it taxed before going into your account. The invested funds also have a better shot to compound and get larger than if they were taxed before putting them in. Additionally, there’s a good chance you’ll be in a lower tax bracket when you finally begin pulling your money out.

Roth 401(k)s

With Roth 401(k)s, you pay taxes on your money before it goes into your investment account. When it comes time to withdraw your savings in the future, it won’t count as taxable income — meaning you don’t owe any taxes on it.

It’s important to note that, while Roth plans don’t incur taxes upon withdrawal, you still must be 59 and a half years old to do so. The IRS will enforce the 10% penalty tax if you take money out earlier than this.

Catch-Up Contributions

If you’re 50 years old and older, catch-up contributions are a way to put more money in your account if you’ve already reached the annual limit. As of 2024, you can put in up to $7,500 per year on top of the contributions you’ve put in. 

This helps you get more in your account if you started it later in life or want to defer more money for retirement. According to the ICI, some employers even match catch-up contributions up to a certain extent.

Leaving Your Job

What happens to your 401(k) if you leave your job? In this case, you have some options. But it’ll depend on your plans. Here’s what you can do:

Leave Your 401(k) Alone 

You can opt to retain your 401(k) from your previous firm, but this is often only the case if you have $5,000 or more in it. Under this amount, you’ll likely have to transfer your money to another account or cash it out.

In some cases, if you have less than $1,000, your former employer will require you to close your account. This is because it’s not feasible to manage an account of this size for a former employee.

Roll Over to Your New Employer’s Plan

If you’re changing employers, another option is rolling the funds from your account into your new firm’s plan. Switching your 401(k) over can be a good idea if your new employer offers better benefits, such as matching or a wider selection of investments. Rolling your account over isn’t always an option, though. So, you’ll have to make sure your new company allows it.

Be aware, as well, that some companies may require you to work for a certain amount of time, such as 90 days, before you can begin to reap retirement plan benefits. So, if you’re interested, it’s a good idea to ask about or research the requirements. You can also begin the rollover process by cashing out your account, but you’ll have 60 days to move the money to your new account.

Roll Over to an IRA

You can also roll over your 401(k) to an individual retirement account (IRA). This strategy allows you more freedom in terms of investment choices. It also lets you continue a tax-deferred plan. 

Once you open your new account, you can arrange for a direct transfer. Or, if you cash out your account before you roll it over, you’ll have 60 days to transfer some or all of it to your IRA.

Cash Out the Account

If you’re leaving your job, a final option is closing your account and pulling out your money. If you’re not at the minimum age, however, you’ll face a 10% tax penalty for doing this. Because of this, cashing out your account isn’t necessarily the best option for most people. But it’s always on the table if you want to tie up loose ends or need money immediately.

Should I Enroll in a 401(k)?

Establishing a 401(k) has a nice set of advantages, specifically regarding taxes. But they’re not always the best choice for everybody, especially if you want more control over your retirement investments. Here are some advantages and disadvantages to setting one up.

Pros

• Federal protection.
• 401(k) must be administered by fiduciaries.
• High contribution limits.
• Pre-tax investing and growth.
• Employer matching.
• Emergency loan possibility.
• Free advice may be included. When a company uses a larger investment firm to administer a 401(k), they send advisors to work with employees to help them maximize their plans.
• Reduction of tax liability because of pre-tax contributions. If you think you may cross a taxation threshold that puts you into a higher tax bracket, you can max out your pre-tax contributions.

Cons

• Limited investment options.
• Fees may be high.
• Early withdrawal penalties.
• Very little guidance on investments.

Frequently Asked Questions

Should I pick a traditional or a Roth 401(k)?

Deciding between a traditional, tax-deferred plan and an after-tax Roth plan will depend on various factors. You’ll want to decide whether it makes sense to save on taxes now or later. According to an article by Fidelity, one way to figure this out is to ask whether you value having more money today or in retirement. Traditional accounts reduce your tax dollars in the current year, while Roth plans lead to you paying taxes now with the idea that you’ll have more in the future.

It’s never a bad idea to consult with a professional while planning for retirement. A financial advisor can help clear up which type of 401(k) is best for your situation.

Can you withdraw from a 401(k) before you’re 59 and a half?

You can withdraw money from your 401(k) early. But not without a penalty. Each time you do so before you’re 59 and a half, you’ll face a 10% excise tax, as well as federal and state income tax.

What’s the difference between a 401(k) and an IRA?

A 401(k) is an employee retirement plan where you have a limited set of investment options and you make contributions that, in some cases, employers may match. Conversely, an IRA is a personal retirement savings account where you make contributions up to a certain limit and are free to invest in an array of options, including stocks, bonds, mutual funds, and ETFs.

What’s the penalty for not taking a required minimum distribution?

The IRS imposes a 50% excise tax on any required amount you haven’t yet taken out of your account if you don’t perform the RMD on time. This can eat away at the earnings you’ve worked hard to compile. If you have RMDs, the IRS typically gives you until December 31.