What is a 401(k) and How Does It Work? A Complete Guide

If you’re a working professional thinking of saving for a retirement plan, investing in a 401(k) is one of the best options available in the market. A 401k plan is a retirement savings plan offered by many American employers that provides tax benefits to the saver. Commonly offered as an extra benefit, you can decide to invest a percentage of your salary in a 401k account, with some annual limitations. Often, employers also match a portion of the employee’s contributions. 

It is one of the most popular retirement plans in the USA. Although it is exclusive to the United States of America, it is a benchmark in retirement planning. The name also comes from Internal Revenue Code that also governs these plans. 

The employee who signs up for a 401k complies with transferring a percentage of their salary to an investment account. Additionally, the employee also gets to choose from a number of investment options. 

If you are planning to sign up for a 401k or simply looking to look more into this topic, here’s everything you need to know. 

What is a 401(k)? 

A 401k is an employer-sponsored retirement plan that offers you a tax break when you save a portion of your salary for retirement. When you sign up for a 401k, you agree to have a percentage of your salary transferred directly to your 401k account. One of the best things about a 401k is that your employer also deposits money into your account by matching all or some of your contributions. 

Employees also get to choose from a number of investment options including mutual funds and exchange-traded funds. However, there is a huge difference in investment options available in various 401k plans, with some offering more options than others. Either way, you get a tax break from your investments, protecting you from income taxes and capital gain taxes. 

There are typically two types of 401k accounts available- 

• Traditional 401k
• Roth 401k 

We will talk about these types later in the blog. In the meantime, let’s see how the 401k account works. 

How Does a 401k Work?

The 401k plan allows the employee to decide to invest a portion of their paycheck in an investment account. The money deducted is further invested in a long-term chosen plan. With a 401k plan, an employee can invest in stocks, mutual funds, bonds, etc. 

A 401k is one of the best perks an employee can get. Even without employer contribution, a 401k plan offers much higher interest rates than that of a savings account. 

Unlike traditional retirement plans where the employer promises monthly benefits at retirement, 401k plans are funded by deducting a portion of the salary each month from the employee’s paycheck. While a 401k plan and its benefits differ from employer to employer, most companies match contributions up to at least 4 to 5% of your annual salary. 

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Getting Started With a 401k

While 401k plans are relatively similar, it ultimately depends on the employer’s plan. Here are some factors that you must understand before you get started with the plan- 

• Company’s Eligibility Requirements
• Whether you will be automatically enrolled or not?
• Does your employer offer a matching contribution? If yes, how much?
• What investment options does the plan offer? Are those options more expensive than other options?
• Does the plan offer the ability to have the account managed for you or other third-party options?
• Can you invest in individual securities or do you have to invest only in the funds provided by the plan?
• Can you take a loan against your account balance? If yes, how much does the loan cost?

These are some of the important questions that you should answer before you get started with your 401k retirement plan. Make sure to understand these stipulations carefully as your employer can make important changes in the plan like the matching contribution. 

Types of 401k Retirement Plans

Primarily, there are two types of 401k retirement plans, each with distinct tax benefits. 

Traditional 401k

In a traditional 401k, the contributions made by the employee are deducted from the gross income. This means the money is deducted from your paycheck before income tax which reduces your total taxable income. Moreover, no taxes are due on either the contributed money or the investment earnings until they are withdrawn. 

Roth 401k 

Unlike traditional 401k, the contributions are deducted from your after-tax income. This means contributions are deducted from your paycheck after the income tax. As a result, you will not get any tax dedication in the year of your contribution. However, when you withdraw the money at retirement, you are not liable for any taxes on either the contribution or the investment earnings. 

An important thing to note is that even though contributions are made after tax deductions if you withdraw your money before the age of 59 ½, you could be liable to tax. Make sure to consult with an accountant or a financial advisor before withdrawing money from a Roth or Traditional 401k. 

However, not all employers offer Roth 401k. If your employer is offering a Roth 401k, you can choose between a Roth or traditional 401k account. You can also contribute in both up to the annual contribution limit. 

Note: You can choose a Roth 401k if you believe you will be in a higher tax bracket in the future. For young adults at the beginning of their careers, lower tax brackets and income levels can make 401k a great choice. 

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How Much Should You Contribute to a 401k Plan?

When it comes to what percentage of your pay you should contribute, it ultimately comes down to your particular needs after retirement. However, there are still some rules you can follow- 

According to experts, an employee should contribute enough to take advantage of any matching dollars offered by your employer. Whether your company offers equal dollar-for-dollar or 50 cents on a dollar, you should accept the match. 

After you have saved enough to completely match your employer, you should consider paying off high-interest debts and creating an emergency fund. Then, maximize your tax advantage retirement accounts whether it's traditional or Roth 401k. 

According to the Investment Company Institute, as of September 30, 2022, 60 million Americans invest in 401k retirement plans and these 401k plans hold approximately $6.3 trillion in assets. 

In recent decades, traditional pension plans have become rare and people are now more invested in 401k retirement plans. Employers have transferred the responsibility and risk of saving for retirement to the employee. 

Employees are also required to choose particular investment options within their 401k accounts offered by the employer. These offerings typically include a variety of stocks and mutual funds designed to reduce the risk of losses as the employee reaches the age of retirement.

They may also include guaranteed investment contracts(GICs) issued by insurance companies and sometimes the employer’s own stock. 

Contribution Limits

The maximum account you or your employer can contribute to a 401k account is adjusted regularly to account for inflation, which is a metric that measures rising prices in an economy. 

In 2022, the annual limit for employee contributions for people below age 50 was $20,500 per year. However, employees aged 50 or more could make a $6500 catch-up contribution. 

In 2023, the annual limit for employee contributions for people below age 50 is $22,500. However, for employees aged 50 and more, you can make a $7500 catch-up contribution. 

Another important thing to note is if your employer contributes or you choose to make additional non-deductible after-tax contributions to your traditional 401k account, there is a set limit for the total employee-and-employer contribution amount for the year. 

• In 2022, for employees under 50 years of age, the total employee-employer could not exceed $61,000 per year. 
• For employees over the age of 50, the total catch-up contribution could not exceed $67,500

• In 2023, for employees under 50 years of age, the total employee-employer contribution cannot exceed $66,000 per year. 
• For employees over the age of 50, the total catch-up contribution can not exceed $73,500.

Employer Matching

Employer matching ultimately depends from employer to employer. Various formulas are used to calculate the amount an employer will match. 

For example- an employer can match 50 cents for every dollar contributed by the employee, up to a certain percentage of the salary. 

According to experts and financial advisors, employees must contribute enough money to get the full advantage of the employer match in their 401k accounts. 

A Tax Savings Example 

For example- let’s consider that you earn $50,000 per year and you decide to invest $2500 a year into your 401k account. You’ll have $104.17 deducted from each paycheck before taxes have been applied. This money goes straight into your 401k plan. 

The earned income you will report on your income tax return at the end of the year will be $50,000-$2,500= $47,500. The $2500 you invested in your retirement plan translated to $625 less in federal taxes if you are in the 25% tax bracket. 

Therefore, savings of $2,500 for retirement only cost $1,875 as you saved $625 on taxes. 

How to Choose Investments for Your 401k?

If you are planning to invest in a 401k retirement plan, here are some things you can consider to earn a higher return with your investment- 

• When it comes to investment, avoid being too selective when you’re younger and too aggressive when you’re old. 
• When you are in your 20s or 30s, you can afford to be more aggressive with your investments. You can invest more of your money into higher-returning funds or stock funds. 
• One of the best advices from legendary investor Warren Buffet was investing in index funds. Index funds based on Standard or Poor’s 500 index are great picks for the stock portfolio. 
• As you age, your assets should be targetted towards more selective investments to protect your portfolio from the volatility of stocks. 
• You can use tools offered by 401k provider like online calculators, worksheets, and more to determine risk tolerance and suitable investment options. 
• If you lack the knowledge or not willing to select funds and building an investment portfolio, the best option might be a financial advisor or an accountant. Select an advisor that can design a long-term investment plan for you and also assist you in following it closely. 
• One of the most important factors when investing for retirement is time. Finding an investment is not more important than finding an investment and buying and holding it for years.

Why Invest in a 401k Retirement Plan? 401k Benefits

A 401k is one of the best retirement plans and considered as a benchmark all around the world. Everyone should consider opening an account if they can. However, not all employers offer a 401k retirement plan. But if your does, it is an amazing opportunity to open an account for the following reasons- 

Tax Advantages

If you’re looking for a tax free investment option and save money at the same time, 401k is one of the best options for you. A 401k lets you invest on a pre tax basis so you can take a considerable break on this year’s tax amount. In traditional 401k, you will be able to grow your assets free of tax until your withdraw them at retirement, when you will owe ordinary tax rates. 

However, in Roth 401k, you can contribute money on an after tax basis and enjoy tax free withdrawals.

Matching Contributions

Another great benefit of 401k is that many employers offer matching contributions if you also contribute money to your retirement plan. You may be able to get an extra 3 or 4% of your salary and get a risk-free return. But some plans require a few years before the employer contribution matches yours. 

Automatic Investments

Once you set up an 401k retirement plan, your money will automatically be contributed from your salary and invest in the funds you have selected. 

Attractive Investments

Most 401k plans offer high-return investment like stock funds so you can earn much more than you could in a traditional savings account over time. 

Key Takeaways

• 401k accounts are generally offered by the employer that you personally fund fom a portion of your salary until you retire. 
• In most cases, you are only required to pay taxes on your funds if you make early withdrawals from your account. 
• More often than not, employers also match your 401k contributions. 
• If its possible, you should contribute enough money to take full advantage of your employer’s match. 
• There are primarily two types of 401k plans- Traditional 401k and Roth 401k
• Employer contributions are made to both a traditional and Roth 401k accounts. 
• Withdrawals from a traditional 401k account are subjected to tax implications. 
• On the other hand, Roth 401k withdrawals are not subjected to any tax implications and are essentially tax free. 
• There are several advantages of investing in an 401k account like tax advantages, matching contributions, and automatic and attractive investments.

Frequently Asked Questions(FAQs)