What Is a 401(k) Plan, and How Does It Work?

Many employers offer 401(k) plans to employees as part of their benefits package. This plan allows workers and employers to claim a tax deduction when they put money into a retirement account.

Your employer must follow certain rules to be able to offer a 401(k). The Employee Benefits Security Administration, part of the U.S. Department of Labor, regulates this plan and explains the rules.

What is a 401(k) Plan?

A 401(k) plan is a special type of account that is funded through payroll deductions made before taxes are paid on the balance. Funds in the account can be put into a variety of investments, usually mutual funds that contain stocks or bonds. They are not taxed on any capital gains, dividends or interest until the income is withdrawn.

Tax Benefits and Contributions Before Tax

Employers first started offering 401(k) plans when Congress passed the Income Act of 1978. Usually you have income taxes withheld from the money you earn as an employee. A 401(k) plan allows you to avoid paying income tax in the current year on the amount you put in your plan, up to the 401(k) contribution limit.

The amount you enter is called a “salary deferred contribution”, because you have chosen to defer some of the salary you earn today for inclusion in the plan. You can save this money so you can spend it in your retirement years. The money grows tax-deferred in the plan.

“Tax-deferred” means you don’t have to pay taxes on profits until you take the money out of the plan.

You only pay taxes on that amount when you withdraw money in retirement. You will pay penalty tax and 10% income tax if you withdraw your funds too early, before age 55 or 59 1/2. The age limit depends on the rules of your 401(k) plan.

The most you can invest in your 401(k) account depends on your plan, your salary, and government guidelines. Your annual salary deferral limit is set by the IRS. This limit is $19,500 in 2021 and $20,500 in 2022.

The contribution limit rises periodically in increments of $500 based on changes in the cost of living.

You can contribute an additional amount if you are 50 years of age or older if your employer offers this “pursuit” contribution. This cap is an additional $6,500 in 2021 and 2022.

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Tax Saving Example

Assume you make $50,000 per year. You decide to put 5% of your salary, or $2,500 a year, into your 401(k) plan. You will earn $104.17 of each paycheck before taxes are applied if you are paid twice a month. This money goes into your plans.

The earned income that you report on your tax return at the end of the year will be $47,500 instead of $50,000 because you can deduct the earned income by the amount you put into your plan. The $2,500 you put into the plan means $625 less in federal taxes paid if you’re in the 25% tax bracket. Saving $2,500 for retirement, therefore, only costs you $1,875.

Roth Contribution 401(k)

Many companies also offer Roth 401(k) plans. You cannot deduct the income earned by the amount you contribute with this plan, but all funds grow tax free. You can also take all your withdrawals tax free.

Before Tax or After Tax?

It’s often best to make a pre-tax contribution to your plan in the years you earn the most. This may be the middle and final stages of your career. Provide your Roth contributions using after-tax dollars during years when your income and tax rates were not as high. These years often occur during the early stages of a career or during gradual retirement when you are working part time.

Employer Contribution

Many employers will contribute to your 401(k) plan for you. There are three main types of employer contributions: matching, non-preferred, and revenue sharing. Employer contributions are always pre-tax, so they will be taxed when you collect the money.

Suitable Contribution

Your employer only puts money into the plan if you do. This may match your contribution dollar for dollar, up to the first 3% of your salary, then 50 cents on the dollar, to the next 2% of your salary.

Your employer will add $2,000 if you pay 5% of your $50,000 salary, or $2,500 a year. That would match the first 3% of your salary, or $1,500, entering $1,500. That would match 50 cents, or $500, on the next 2% of your paycheck, or $1,000. The total contribution on your behalf will be $2,000 for the year.

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It almost always makes sense to donate enough money to receive a match if your employer offers it.

Non-Elective Contribution

Your employer may decide to include a certain percentage in the plan for all workers, regardless of whether you include their own money. The employer can contribute 3% of salary to the plan annually for all eligible employees.

Profit Sharing Contribution

The company can choose to include a set dollar amount into the plan if it makes a profit. Different formulas determine how much can be given to which worker. The most common formula is that all workers receive an amount commensurate with their salary.

When will the money be yours?

Certain types of suitable employer contributions are subject to the vesting schedule. The money is in your account, but you will only get a portion of what the company gives you if you leave your job before you get 100% entitlement. You can always save the money you personally put into the plan.

Discrimination Rules

Employers cannot create a 401(k) plan solely to benefit themselves or their highly paid employees. A plan must be tested annually to ensure it meets these rules, or an employer can create a special plan called a “401(k) safe port plan”, which allows them to skip the testing process. This 401(k) plan will “pass” one of the tests as long as it is entered into the legally required amount, either as a match or as a non-elective contribution. Any suitable or non-elective contribution that the employer makes to you is right away with a safe harbor plan.

Profit sharing contributions may still be subject to the vesting schedule.

Investment Options

Most 401(k) plans offer at least three investment options. They have very different levels of risk. You should receive education about your choices. Government regulations also limit the number of employer shares or other types of assets that can be used in a 401(k) plan.

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The most common type of investment offered in 401(k) plans are mutual funds because of this rule.

Many plans set up default options, such as certain mutual funds. All the money goes there unless and until you go online or contact your plan administrator to change it.

Options for Beginners

Most plans offer target date funds based on a specific year in the future that matches the year you think you will retire. This can be a great option for new investors.

Some 401(k) plans also offer a portfolio of models. You will fill out a questionnaire, and options will then be recommended to you. You’re probably better off using a target-date fund or a model portfolio unless you’re a savvy investor or you work with a financial planner to tell you. This default option is often a very easy way to invest.

Another rule to follow

A 401(k) plan must follow several other rules to determine who is eligible, when money can be paid out of the plan, whether loans can be allowed, and when money should be included in the plan. You can find a lot of info on Retirement Plan FAQ US Department of Labor website page.

Frequently Asked Questions (FAQ)

How does a 401(k) work once you reach retirement?

If you are retired and have reached the minimum age required by your plan, then you are free to withdraw from your account without penalty. The exact process will depend on the company managing your 401(k), but you are free to sell your investments and withdraw money in retirement as you please. Withdrawals from a regular 401(k) plan will be taxed at your income tax rate. Roth 401(k) withdrawals are tax free.

How does allocation work with a 401(k) plan?

Not all 401(k) plans give you the same amount of freedom to allocate funds as you wish. Some will allow you to rebalance your portfolio from a pre-selected list of investments. Others may give you more freedom. There are also plans that are fully managed by 401(k) companies that don’t give participants any vote in the allocation. Contact your human resources department to learn more about your options for adjusting your allocation of funds.

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