Understanding 401(k)s and All Their Benefits

October 22, 2016 — 6:00 AM EDT

While you’ve undoubtedly heard of these wildly popular employer-sponsored retirement plans, fully understanding 401(k)s is another story. More than 50 million workers are active participants in their employers’ 401(k) plans today, with over half a million different company plans in place. Representing 18% of all retirement assets held in the nation, 401(k) plans in the U.S. hold a total of $4.5 trillion in assets.

So why are these retirement plans all the rage with American employees? Keep reading to learn more about 401(k)s and the valuable advantages these plans provide.

Understanding 401(k)s

Named after a section of the Internal Revenue Code, 401(k)s are defined contribution plans sponsored by employers as a retirement investment vehicle. If your employer offers a 401(k), you can contribute a percentage of your income, which is automatically deducted from your paycheck.

The IRS limits the amount you can invest in a 401(k). In 2016, the 401(k) contribution limit is $18,000. However, people 50 or older who expect to hit the 401(k) elective deferral limit can contribute an additional sum of up to $6,000 for a total of $24,000. This is known as the catch-up contribution limit.

The average 401(k) plan offers numerous investment options, and many include additional features such as automatic enrollment, increased fee visibility and low-cost index fund options. Plus, 401(k) contribution limits are indexed to inflation, which means you can make larger contributions to your plan as inflation increases.

However, there are restrictions on how and when you can withdraw money from the account. If you withdraw funds from a 401(k) before you reach retirement age, you’ll be hit with a 10% early-withdrawal penalty fee as well as any applicable taxes. (For related reading, see Top 10 Mistakes to Avoid on Your 401(k).)

The Benefits

Here are some of the benefits 401(k) plans have to offer:

Tax Advantages

401(k) plans offer numerous tax benefits. First off, you can contribute a certain percentage of your income to a 401(k) on a pretax basis. In other words, the amount you contribute to your 401(k) is exempt from current federal income tax, so it lowers your taxable income.

To top it off, your 401(k) earnings accrue on a tax deferred basis. That means the dividends and capital gains earned inside your 401(k) are not subject to taxes until you begin withdrawing from the plan. You (one hopes) won’t be making withdrawals until after you retire, when you’ll likely be in a lower tax bracket. (Most people earn a smaller income after retirement, which places them in a lower tax bracket. This means you’ll likely pay fewer taxes on 401(k) withdrawals.)

Matching Contributions

Some employers offer matching contributions to your 401(k) plan, and they may also add a profit-sharing feature to the plan. If your company offers a matching contribution, it’s essentially free money. Many companies offer 50% of the first 6% you contribute to a 401(k). So let’s say you earn a $45,000 salary. If you contribute 6% of your pay ($2,700), your employer would contribute 50% of that amount to your 401(k). That’s $1,350 of easy money! Even better, some employers offer a dollar-for-dollar match for the first 6%. In this scenario, your employer would match your contribution of $2,700. Plus, employer contributions do not count toward your annual contribution limit.

Lifetime Contributions

When you turn 70½, you can no longer contribute to some retirement accounts, including traditional IRAs – even if you’re still working. At this age, you also must take what’s called required minimum distributions (RMDs) from some retirement plans. These withdrawals lead to a higher income, which in turn results in higher tax rates.

Unlike many retirement accounts, you can contribute to a 401(k) for as long as you want if you are still working. Plus – while you're working – you do not have to take RMDs from your employer's 401(k), as long as you own less than 5% of the business that employs you.

Shelter from Creditors

Yet another advantage of 401(k)s? These retirement plans offer excellent creditor protection. That’s because a 401(k) is considered an ERISA-qualified retirement account, which means it was set up under the Employee Retirement Income Security Act (ERISA). ERISA accounts are generally protected from judgment creditors.

Additionally, 401(k)s often offer some protection from federal tax liens, a federally authorized lien against assets of a taxpayer who has unpaid back taxes. Because 401(k) plans legally belong to your employer, it makes it difficult for the IRS to place a lien on the account. Depending on the language contained in the fine print of your account, your plan administrators may be able to refuse to comply with an IRS lien.

Roth 401(k) Option

There is another 401(k) plan that combines the traditional 401(k) with a Roth IRA. Established in 2006, the Roth 401(k) offers participants a different tax-advantaged option. With these plans, you make contributions with after-tax dollars, but withdrawals are fully tax-free as long as certain conditions are met. In other words, while you do have to pay tax on your contributions to a Roth 401(k), you won’t have to pay any tax when you withdraw the money in retirement. All the money in your account grows tax-free. This type of plan is ideal for people who think they will be in a higher tax bracket in retirement than they are now.

Additionally, unlike Roth IRAs, there are no income limits on being able to contribute to a Roth 401(k). You can only contribute to a Roth IRA if your income is below a certain threshold. (In 2016, that income max is $133,000 for single filers and $194,000 for married filers.) Therefore, Roth 401(k)s offer an avenue for high earners who want to invest in a Roth without converting a traditional IRA. The Roth 401(k) option is available in more than 50% of company 401(k) plans. (See also: Are Roth 401(k) Plans Matched by Employers?)

The Bottom Line

It’s no wonder the 401(k) is the most popular employer-sponsored retirement plan in the nation. From tax advantages to employer matching contributions to shelter from creditors, 401(k) plans offer numerous benefits. If your employer offers a 401(k) plan, it would be a mistake not to contribute to it.