What Is a 401(k) Plan?

A 401(k) plan is a tax-advantaged, defined-contribution retirement account offered by many employers to their employees. It is named after a section of the U.S. Internal Revenue Code. Workers can make contributions to their 401(k) accounts through automatic payroll withholding, and their employers can match some or all of those contributions. The investment earnings in a traditional 401(k) plan are not taxed until the employee withdraws that money, typically after retirement. In a Roth 401(k) plan, withdrawals can be tax-free.

Key Takeaways

  • A 401(k) plan is a company-sponsored retirement account that employees can contribute to. Employers may also make matching contributions.
  • There are two basic types of 401(k)s—traditional and Roth—which differ primarily in how they're taxed.
  • In a traditional 401(k), employee contributions reduce their income taxes for the year they are made, but their withdrawals are taxed. With a Roth, employees make contributions with post-tax income, but can make withdrawals tax-free.

Understanding 401(k) Plans

There are two basic types of 401(k) accounts: traditional 401(k)s and Roth 401(k)s, sometimes referred to as a "designated Roth account." The two are similar in many respects but are taxed in different ways. A worker can have either type of account or both types.

Contributing to a 401(k) plan

A 401(k) is what's known as a defined-contribution plan. The employee and employer can make contributions to the account, up to the dollar limits set by the Internal Revenue Service. By contrast, traditional pensions (not to be confused with traditional 401(k)s) are referred to as defined-benefit plans; the employer is responsible for providing a specific amount of money to the employee upon retirement. In recent decades, 401(k) plans have become more plentiful and traditional pensions increasingly rare, as employers have shifted the responsibility and risk of saving for retirement to their employees.

Employees are also responsible for choosing the specific investments within their 401(k) accounts, from the selection their employer offers. Those offerings typically include an assortment of stock and bond mutual funds as well as target-date funds that hold a mixture of stocks and bonds appropriate in terms of risk for when that person expects to retire. They may also include guaranteed investment contracts (GICs) issued by insurance companies and sometimes the employer's own stock.

Contribution maximums

The maximum amount that an employee or employer can contribute to a 401(k) plan is adjusted periodically to account for inflation. As of 2019, the basic limits on employee contributions are $19,000 per year for workers under age 50 and $25,000 for those 50 and up (including the $6,000 catch-up contribution). If the employer also contributes (or if the employee elects to make additional, non-deductible after-tax contributions to their traditional 401(k) account), the total employee/employer contribution for workers under 50 is capped at $56,000, or 100% of employee compensation, whichever is lower. For those 50 and over, the limit is $62,000.

In 2020, all those figures go up. Basic contributions rise to $19,500 and the catch-up to $6,500. The cap, including employer contributions, becomes $57,000—$63,500 for those 50 and older.

Employer matching

Employers who match their employee contributions use different formulas to calculate that match. A common example might be 50 cents or $1 for every dollar the employee contributes up to a certain percentage of salary. Financial advisors often recommend that employees try to contribute at least enough money to their 401(k) plans each to get the full employer match.

Organizing your account

If they wish—and if their employer offers both choices—employees can split their contributions, putting some money into a traditional 401(k) and some into a Roth 401(k). However their total contribution to the two types of accounts can't exceed the limit for one account (such as $19,500 in 2020). Employer contributions can only go into a traditional 401(k) account, where they will be subject to tax upon withdrawal.

Taking withdrawals from a 401(k) plan

Participants should remember that once their money is in a 401(k), it may be hard to withdraw without penalty. "Make sure that you still save enough on the outside for emergencies and expenses you may have before retirement. Do not put all of your savings into your 401(k) where you cannot easily access it, if necessary," says Dan Stewart, CFA®, president of Revere Asset Management, Inc., in Dallas, Texas.

The earnings in a 401(k) account are tax-deferred in the case of traditional 401(k)s and tax-free in the case of Roths. When the owner of a traditional 401(k) makes withdrawals, that money (which has never been taxed) will be taxed as ordinary income. Roth account owners (who have already paid income tax on the money they contributed to the plan) will owe no tax on their withdrawals, as long as they satisfy certain requirements.

Both traditional and Roth 401(k) owners must be at least age 59½—or meet other criteria spelled out by the IRS, such as being totally and permanently disabled—when they start to make withdrawals. Otherwise, they will face an additional 10% early-distribution penalty tax on top of any other tax they owe.

Both types of accounts are also subject to required minimum distributions, or RMDs. (Withdrawals are often referred to as "distributions" in IRS parlance.) After age 70½, account owners must withdraw at least a specified percentage from their 401(k) plans, using IRS tables based on their life expectancy at the time. If they are still working and the account is with their current employer, however, they may not have to take RMDs from that plan. (Roth IRAs, unlike Roth 401(k)s, are not subject to RMDs during the owner's lifetime.)

Traditional 401(k) vs. Roth 401(k)

When 401(k) plans first became available in 1978, companies and their employees had just one choice: the traditional 401(k). Then, in 2006, Roth 401(k)s arrived. Roths are named for former U.S. Senator William Roth of Delaware, the primary sponsor of the 1997 legislation that made the Roth IRA possible.

While Roth 401(k)s were a little slow to catch on, many employers now offer them. So the first decision employees often have to make is: Roth or traditional?

As a general rule, employees who expect to be in a lower marginal tax bracket after they retire might want to opt for a traditional 401(k) and take advantage of the immediate tax break. On the other hand, employees who expect to be in a higher bracket might opt for the Roth so that they can avoid taxes later. For example, a Roth might be the right choice for a younger worker whose salary is relatively low now but likely to rise substantially over time. Also important, especially if the Roth has years to grow: No tax on withdrawals means that all the money the contributions earn over decades of being in the account is also not taxed.

Since no one can predict what tax rates will be decades from now, neither type of 401(k) is a sure thing. For that reason many financial advisors suggest that people hedge their bets, putting some of their money into each.

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Introduction To The 401(K)

Special Considerations: Changing Jobs

When an employee leaves a company where they have a 401(k) plan, they generally have four options:

1. Withdraw the money

This is usually a bad idea unless the employee absolutely needs the cash for an urgent purpose, such as a medical bill. Not only will the money be taxable in the year it's withdrawn, but the employee may also be hit with the additional 10% early-distribution tax unless they are over 59½, totally and permanently disabled, or meet the other IRS criteria for an exception to the rule.

In the case of Roth IRAs, the employee's contributions may be withdrawn tax-free and without penalty at any time, but earnings will be taxable if the employee is under 59½ and has had the account for less than five years. And even if the employee is able to withdraw the money tax-free, they will be diminishing their retirement savings, which they may regret later in life.

2. Roll it over into an IRA

By moving the money into an IRA at, say, a brokerage firm or mutual fund company, the employee can avoid immediate taxes and maintain their account's tax-advantaged status. What's more, the employee is likely to have a wider range of investment choices in an IRA than with their employer's plan.

The IRS has relatively strict rules on rollovers and how they need to be accomplished, and running afoul of them can be costly. Typically, the financial institution that is line to receive the money will more than happy to help with the process and avoid any missteps.

Money in a 401(k) or an IRA is usually shielded from creditors.

3. Leave it with the old employer

In many cases, employers will permit a departing employee to keep a 401(k) account in their old plan indefinitely, although the employee can't make any further contributions to it. This generally applies to accounts worth at least $5,000; in the case of smaller accounts, the employer may give the employee no choice but to move the money elsewhere.

Leaving 401(k) money where it is can make sense if the old employer's plan is well-managed, and the employee is satisfied with the investment choices it offers. The danger is that employees who change jobs over the course of their careers can leave a trail of old 401(k) plans and may forget about one or more of them. Their heirs might also be unaware of the existence of the accounts.

4. Move it to the new employer

Some companies allow new employees to move an old 401(k) into their own plan. As with an IRA rollover, this can maintain the account's tax-deferred status and avoid immediate taxes. It could be a wise move if the employee isn't comfortable with making the investment decisions involved in managing a rollover IRA and would rather leave some of that work to the new plan's administrator.

In addition, if the employee is nearing age 70½, note that money that is in a 401(k) at one's current employer is not subject to RMDs. Moving the money will protect more retirement assets under that umbrella.