A 401(k) is a staple for many people’s retirement planning, so it’s important to understand how they work. Browse Investopedia’s expert-written library to learn more.
Maximize Your 401(k)
What are the 401(k) withdrawal rules?
Contributions and earnings in a Roth 401(k) can be withdrawn if you are at least 59½ and have had your account for at least five years. If you withdraw from your 401(k) before then, you’ll have to pay income tax on the amount you withdraw as well as a 10% IRS tax penalty on some of the amount. Withdrawals can be made without penalty if you become disabled or by a beneficiary after your death.Learn More: Learn the Rules for 401(k) Withdrawals
What is a good 401(k) match?
If your company offers an employer-sponsored retirement plan, chances are it’s a 401(k). If you’re lucky, your employer might even match some of your contributions to that account, meaning you get free money added to your retirement savings. The average match by employers was 4.5%, according to Vanguard's annual report on investing behavior.Learn More: What Is a Good 401(k) Match?
When does paying off debt with a 401(k) make sense?
Withdrawing early from your 401(k) should be a last resort. If you withdraw money from your 401(k) before retirement, you’re going to encounter some fees and penalties, not to mention impact your retirement savings. Knowing this, you should do everything in your power to reduce your debt in other ways, like negotiating with your credit companies, or taking out a loan from your 401(k). This way, you pay the money back to your retirement account without losing the money in your account.Learn More: When to Pay off Debt With a 401(k)
Are 401(k) contributions tax deductible?
Contributions made to traditional 401(k)s and other qualified retirement plans are made with pre-tax dollars, so they are deductible from your taxable income. This works out in your favor, as the money you contribute to your 401(k) actually shrinks your total income for the year, in turn slightly reducing your taxes as well. However, there are limits to how much you can contribute to these plans. For 2021, the limit is $19,500, and in 2022 the amount goes up to $20,500.Learn More: Tax Deductibility and 401(k) Contributions
What happens to a 401(k) after you leave your job?
There are several options of what you can do with your 401(k) after you leave your job. If the account has more than $5,000 in it, most plans allow you to leave it where it is. Alternatively, you can roll the balance over into your new 401(k) at your new job. This is beneficial because then your interest is still compounding on the whole amount, instead of compounding on two smaller amounts in two different 401(k)s. Lastly, you can choose to cash out your 401(k), though this is usually not recommended as you’ll have to pay fees and penalties on the amount and you will lose out on retirement savings.
An in-service withdrawal is when an employee withdrawals money from an employer-sponsored retirement account before they are qualified to do so. An early withdrawal from a 401(k) is the most obvious example. However, early withdrawals and in-service withdrawals are not necessarily the same thing. Withdrawing money from a certificate of deposit (CD) before it has matured can also be considered early withdrawal, but would not be considered an in-service withdrawal.
A brokerage window is an option offered in a 401(k) plan that gives the investor the capability to buy and sell investment securities on their own through a brokerage platform. While this is a relatively new option for 401(k) plans, it is quickly gaining popularity as more companies give the option to their employees. Brokerage windows may also have higher than average trading costs, with some brokerage windows reporting transaction fees of $8 to $10 per trade.
Defined Contribution (DC) Plan
A defined contribution plan is a retirement plan in which employees contribute a fixed amount or a percentage of their paychecks to an account that is intended to fund their retirements. The most well known DC plan is probably the 401(k). The term DC plan houses all of the DC plan types, like 401(k)s and 403(b)s. In contrast, a defined benefit (DB) pension plan is a plan in which the employer offers to fund an employee’s retirement.
A Roth 401(k) works similar to a Roth IRA—you contribute money to it after tax, meaning the money doesn’t come directly out of your paycheck pre tax like a regular 401(k), but you contribute the money voluntarily after it’s already been taxed. These accounts are employer-sponsored, and some people like them because the money they withdraw from them in retirement won’t be taxed. One disadvantage is that your contributions to a Roth 401(k) won’t reduce your taxable income like a regular 401(k) would.
A SIMPLE 401(k) is a retirement savings account that small business can offer their employees. Your business must have less than 100 employees if you want to offer a SIMPLE 401(k). This account works just like a regular 401(k) plan, albeit with a few caveats. For one, if you are the employer, you must contribute to your employee’s SIMPLE 401(k)s. Also, you cannot offer another type of retirement accounts to your employees.
When you are vested in an employer-matching retirement funds or stock options, you have nonforfeitable rights to those assets. Often, the amount in which an employee is vested increases gradually over a period of years until the employee is 100% vested. A common vesting period is 3 to 5 years. Vesting is also common in wills. It often takes the form of a set waiting period to finalize bequests following the death of the testator.