What is a 401(k) Retirement Plan? A Beginner’s Guide

Key Takeaways


There are many different ways to save for retirement, but one of the most popular is the 401(k) retirement plan. What is a 401(k) retirement plan, and how can you use it to maximize your retirement funds? Here is your comprehensive guide.


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401k retirement plan

What is a 401(k)?

A 401(k) retirement plan is an employer-sponsored retirement plan, which means that it’s funded in cooperation with your employer. There are two types of employer-sponsored retirement plans: a “defined-benefit plan” and a “defined-contribution” plan. A 401(k) is a defined-contribution plan (while a pension is considered a defined-benefit plan).

Here’s how a 401(k) retirement plan works. If you work for a company that offers a 401(k), you can contribute a portion of your salary to the account every year. The money that you put into the account is invested by a third-party so the account earns a higher amount of interest over time.

A 401(k) is a “qualified” retirement plan, which means that it receives special IRS tax benefits—the main benefit being that you don’t have to pay taxes on your initial investment earnings. Instead, you’ll only be taxed when you withdraw money after you retire.

Employers have the option of matching your contributions. For example, your employer might decide to match 100% of your contributions, so if you contributed $3,000 per year, then your employer would contribute an additional $3,000. About half of all employers make matching contributions (which typically amount to 3% of an employee’s salary). Other employers match $0.50 for every dollar you contribute.

Employers are not required to contribute anything to your 401(k), and they aren’t even required to offer a 401(k) plan to employees. But it’s a terrific benefit for those employees who are offered one. A 401(k) has a significantly higher interest rate than a standard savings account, even without employer contributions.

Roth 401(k) Vs. Traditional 401(k) Retirement Plans

There are two types of 401(k) retirement plans: a traditional 401(k) and a Roth 401(k). The Roth 401(k) is increasingly popular, but it’s still not offered by a large number of companies.

Under a traditional 401(k), you only have to pay interest on your contributions after you retire and begin to make withdrawals from the account. A Roth 401(k) is the opposite. Under a Roth 401(k), you immediately pay income tax on your contributions. The flip side is that when you retire, you don’t pay any tax on your withdrawals.

To reiterate: under a traditional 401(k), your retirement distributions are taxed as ordinary income, while under a Roth 401(k), your retirement distributions are not taxed.

So what’s better? A traditional 401(k) or a Roth 401(k)?

If you’re in a lower tax bracket, you might prefer a traditional 401(k) because you won’t have to pay immediate taxes and you can keep more money in your pocket and in your paycheck.

If you’re in a higher tax bracket, you might prefer a Roth 401(k). By paying taxes on your contributions now, you could shield yourself from rising tax rates in the future.

However, neither type of 401(k) is entirely dependable. Tax rates are bound to change over the years, which could flub-up your tax plans. Use your budget and retirement goals to best gauge whether you’d want to pay your taxes now or later.

401k retirement plan

Contributing to Your 401(k) Retirement Plan

When you contribute money to a 401(k) retirement plan, the money doesn’t just sit idly in your account. Your account funds will typically be managed by a financial advisory group, and they’ll invest your contributions so you can maximize the interest on your retirement plan. Most employers will give you a choice of several different investment options.

“What?!” you exclaim, as panic embroils you. “I don’t want anybody investing my precious retirement money!”
Don’t worry. The investments are all safe, and tend to include:

Typically, your money will go toward loan-style investments that guarantee a return, plus interest. Your retirement money will not be put into something like a corporate stock, which could significantly depreciate in value and never recover. Your money is very safe.

Nonetheless, you’ll still have to choose an investment option from the several offered by your employer. Be sure you understand how each of the investment options works. Also, familiarize yourself with investment risk.
Above all, try and pick an investment option that has the lowest expense ratio. Remember, you’ll have financial professionals managing your retirement funds and they’ll take a cut of your earnings. Try and pick the lowest-cost option.

401(k) Retirement Plan Contribution Limits

The federal government sets limits on how much you can contribute to your 401(k) per year. As of 2020, you can contribute a maximum of $19,500 to your 401(k) each year. Employees who are 50 and older can make additional “catch-up” contributions up to $6,500 (for those who are late in opening a 401(k) plan).

The maximum amount for joint contributions is $57,000 per year and $63,000 for those who are age 50 and older. For example, if you’re under the age of 50 then you could contribute the maximum $19,500 and your employer can contribute a maximum of $37,500 for the total contribution of $57,000.

There are limits for high-earners. High-paid employees can only contribute the first $285,000 of their income to a 401(k) retirement plan. Most employers may offer high-earning employees a non-qualified plan or an executive bonus plan.

Employer Matching

As mentioned earlier, your employer may offer to match your contributions. How much your employer contributes depends on the terms of your employer’s 401(k) plan.

Here are a few different kinds of employer matching scenarios:

  • 100% Matching: Your employer contributes the same amount of money that you contribute (up to the federal limit).

  • Percentage Matching: Your employer matches a percentage of your contributions. Let’s say that your employer matches 50% of your contributions. If you contributed $3,000, your employer would contribute $1,500. This is the most common type of employer matching scenario. Under these types of plans, you’ll have to contribute more money each year to maximize your employer matching.

  • Dollar Amount: Your employer contributes up to a certain dollar amount. For example, your employer offers to match up to $3,000. You can contribute $5,000, but your employer contribution will still be capped at $3,000. You must contribute the maximum employer contribution to receive it; for example, if you only contribute $2,000, then your employer will also only contribute $2,000.

  • Partial Matching: The employer will match up to 50% of your salary.

Terms vary widely from company to company, so when you’re interviewing for jobs you might want to ask about each company’s 401(k) plan.

401(k) Retirement Plan Withdrawals

The purpose of a 401(k) retirement plan is to help you save enough money to live a comfortable retirement. If you were able to remove money from your 401(k) like it were a checking account, then it would be all too easy to use the money for other expenditures and you could significantly hinder the quality of your retirement. For that reason, there are strict rules on how and when you withdraw money from your 401(k).

Rules for 401(k) Withdrawals

In order to begin withdrawing money from your 401(k), there needs to be a “triggering event.” Here are the triggering events:

  • You retire

  • You die (in which case your family may be entitled to some of your 401(k) funds)

  • You become disabled

  • You reach age 59 ½

  • You suffer an extreme or unusual hardship (COVID-19, for instance—we’ll touch on that next)

  • Your 401(k) plan is terminated

Early withdrawal may result in a 10% tax penalty (10% of however much you withdrew).

The CARES Act of 2020

The CARES Act allows you to receive a “hardship distribution” from your retirement plan (either a 401(k) or an IRA) if you’ve been affected by the COVID-19 pandemic.

Perhaps you got laid off, have incurred substantial medical debt, or have had to assume caregiving responsibilities for a family member. These expenses can place a significant strain on your finances and personal well-being, and so the CARES Act enables you to put some of your retirement funds back into your pocket without having to pay any penalty.

However, your employer has the authority to determine whether or not you’re able to take a hardship distribution. Employers are not required to allow hardship distributions and they can disallow you from taking one, even if you’ve been seriously disaffected by COVID-19 or another kind of hardship.

Again, when you’re searching for a company to work for, you should ask about your employer’s 401(k) plan and whether or not they allow hardship distributions. It could be the deciding factor when you’re weighing job offers.

Retirement Plan Loans

Need a personal loan? You might be able to take out a loan from your 401(k) plan. Under some plans, you may be able to borrow up to 50% vested interest (we’ll talk about vesting schedules toward the end).

Typically, your retirement plan loan must be paid back within five years, so it’s a short-term loan for all intents and purposes. Interest is usually less than a bank loan, so this is an ideal financing option so long as you have the money for repayment and aren’t going to be retiring within five years.

Two things: first, your employer’s 401(k) terms will determine whether or not you’re able to take out a retirement plan loan. Your employer does not have to permit these types of loans. Second, you can not use a retirement plan loan to purchase an investment property. If you’re going to use the money to finance a home, you must be purchasing a primary property that you intend to live in for most of the year.

The CARES Act doubled the amount of money that you can borrow, so you can take out a retirement plan loan up to $100,000 if you’ve been seriously affected by COVID-19.

Post-Retirement Rules

The average retirement age is increasing due to longer lifespans and economic necessity. Even when you’ve reached the age of 59 ½, you don’t have to withdraw money from your 401(k) until you reach age 72. The IRS requires that individuals with a 401(k) receive minimum distributions at age 72. The only exception is if that employee is still working for the company that’s sponsored their 401(k).

Money that you withdraw from your 401(k) is taxed as ordinary income unless you’re withdrawing from a Roth 401(k).

It’s common for retirees to transfer their 401(k) balance to a traditional IRA or a Roth IRA, a transfer that’s referred to as a rollover. Retirees opt for rollovers because an IRA typically has more investment options than a 401(k).

There are two kinds of rollovers:

  • Direct rollover: Your money goes straight from your 401(k) into your new account.

  • Indirect rollover: Your money is sent to you first, and then you deposit the money into your new account.

Most financial advisors strongly suggest that you opt for a direct rollover. A direct rollover has no additional tax obligations. But with an indirect rollover, you’ll have to pay full income tax on the entire amount of money that you’ve withdrawn. That’s a major and unnecessary tax burden.

If your 401(k) features employer stock, then you can also take advantage of net unrealized appreciation (NUA). When you first opened your 401(k), the value of the company stock might have been significantly less than it is when you retire. If so, then you can gain additional earnings based on how much your stock has increased in value. There are a lot of important factors here, so you might want to consult a tax professional on this subject.

401k retirement plan

What Happens if You Leave Your Job?

What happens if you leave a job in which you’ve opened a 401(k) retirement plan?

First, know that you could lose some or all of the money that your employer contributed if you’re fired or resign before a certain number of years has elapsed.

Be sure you know your employer’s vesting schedule. The vesting schedule determines how much ownership you have in your employer’s contributions to your 401(k).

You have 100% ownership of your own contributions, but not of your employer’s. A vesting schedule gives you a gradually increasing ownership over your employer’s contributions for each year that you spend at the company. This is a protective measure for companies. On average, it takes an employee 5 years to be fully vested over their employer’s contributions. Be sure to take the vesting schedule into account when you’re planning your career strategy.

When you leave a company, you’ll have several options on what to do with your 401(k) retirement plan:

  • Withdraw money: You can withdraw all the money you put into your 401(k), but this may be ill-advised because you’d have to pay income tax on all of it.

  • Rollover: You can opt for a rollover and have the money transferred to an IRA or other savings account.

  • Leave it: Some employers may allow former employees to keep a 401(k) plan indefinitely. However, the employee can’t make any further contributions to it. If you work for multiple employers throughout your career and open multiple 401(k) plans, be sure not to leave all that money sitting idly. Consolidate your old 401(k) plans into a single IRA and reap higher interest.

  • Move to new employer: Some companies allow you to rollover your old 401(k) money into their own 401(k). This is similar to an IRA rollover.

Summary

A 401(k) retirement plan is one of the most popular employer-sponsored retirement plans. Under a 401(k), you’ll contribute a portion of your salary to a retirement account, and your employer may match your contributions in full or by percentage. A third-party financial advisory firm will invest the money for you so you can earn higher interest. In order to withdraw money from your 401(k) plan, you must have reached age 59 ½ or have met one of several triggering events—otherwise, you’ll have to pay an early withdrawal penalty.

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