What Is a 401k: Should You Consider This Retirement Investment Plan Option?

A recent study showed that over 40% of Americans have less than $10,000 saved for retirement.

Nearly two-thirds of all workers age 22 and up have access to a retirement plan through their employer, so why are so many people not taking advantage of the opportunity?

It may be that 401k plans aren’t as well understood as they could be. If your employer offers a 401k plan, here’s what you’ll need to know.

what is a 401k
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What is a 401k plan?

A 401k plan is a type of tax-advantaged retirement investment plan offered through an employer.

Both employees and employers can contribute to your 401k account and contributions made to your 401k account are tax-deferred until withdrawal.

Investment choices range from mutual funds to bond funds and money market funds, with gains on investments also tax-deferred until withdrawal.

Because a 401k is designed as a retirement savings vehicle, there are significant restrictions on access to the funds in your 401k, including tax-penalties that may apply if you withdraw money prior to retirement age.

Modern 401k plans offer a wider choice of investments and many plans offer asset allocation features that allow you to match investments to your age and risk tolerance, with a future account value in mind.

Named after Section 401(k) of the Internal Revenue Code, the now-common 401k was created in 1978 as part of the Revenue Act of 1978.

401k plans as we know them today have evolved from a simple savings vehicle that allowed tax-deferred savings to a nearly full-featured investment option that allows several investment types and now even includes an option to take tax-free withdrawals at retirement.

How to start a 401k?

If your employer offers a 401k and you’re eligible to participate, you’ll receive information from your employer on how to start participating.

In larger companies, the human resources department typically handle onboarding for new 401k participants.

Many employers offer matching contributions, which is one of the biggest benefits to using a 401k for retirement planning.

If your employer offers matching contributions, it’s to your advantage to contribute enough that you’ll max out the employer contributions.

Payroll deductions

Your contributions are funded through payroll deductions, so the real starting point is calculating how much you can afford to contribute.

Because you contributions are taken directly from your pay, the amount you contribute often isn’t missed. Instead, you might find you have a bit less money available for frivolous purchases.

This isn’t always a bad thing. Be careful, however, not to contribute money you’ll need for rent, the mortgage, or other necessities.

Investment choices

Most 401k plans offer a choice of mutual funds as well as risk-based asset allocation options.

Asset allocation matches risk and growth opportunities to your age. In general, if you’re younger, you can afford to invest in funds that offer faster growth.

Fast-growth funds can go down as quickly as they go up, so they are a better fit for younger investors who have time to ride out temporary downswings.

Your 401k plan will provide literature that explains the investment goals of each fund, which can make choosing your investments easier.

You can select multiple options and allocate a percentage to each investment option as you see fit or you can choose the premade asset allocation models provided by your plan.

Once you’ve chosen your contribution amount and your investment selections, your 401k usually requires very little interaction.

Making frequent changes to your 401k is often counterproductive and most investors will see better long-term performance by making fewer changes.

Consistent investing

If the market goes down a bit, your contribution can buy more shares and shares are purchased at regular intervals as your contributions are applied to your account.

Later, as fund values increase, you’ll enjoy a larger return across a larger number of shares.

This concept is called dollar cost averaging and is one of the most effective ways of investing. Let’s face it.

Nobody knows for sure what the price of a mutual fund will be tomorrow. Fortunes have been lost trying to outguess the market.

Steady purchasing — regardless of price, however, has proven to be a safer way to invest and can make everyone look like an investment genius.

The long-term trend of the market is up— and remember, the time frame for retirement investing is often measured in decades.

Who is eligible for a 401k?

If your employer offers a 401k, most employees will be able to participate in the plan. Per IRS rules, employees of nearly any age can contribute to a 401k plan, including teenagers.

However, IRS rules also allow employers to set a minimum age or require a certain amount of time on the job before employees can participate in the company’s 401k plan.

IRS 401k rules set the maximum age and service that employers can use as a restriction.

  • Maximum age restriction: 21. Nearly two-thirds of plans set age 21 as the minimum age at which employees can participate in the company’s 401k. This is the highest age employers can use to restrict eligibility.
  • 1 year or 1,000 hours of service. Employers can restrict participation to employees with at least a year of service. However, IRS rules define a year of service as a year in which 1,000 hours are worked. This opens the door to many part time workers as well.

Other rules may also affect eligibility. For example, interns or seasonal workers may be excluded.

Other restrictions can also apply, as long as the employer meets the minimum coverage requirement; at least 70% of employees must be covered by a qualified retirement plan in most cases.

How does a 401k work?

A traditional 401k is a tax-advantaged tool for retirement savings but it isn’t tax free. Instead, your contributions to your 401k and any contributions from your employer are tax-deferred, which means you pay taxes later.

Growth in the value of your account is also tax-deferred, which can help your balance to grow faster than with a taxable investment account.

A simple example to illustrate the advantage

If you decide to invest $1,000 of your income and you choose to use a taxable account, the amount you can invest is reduced because the income is subject to income tax.

Assuming you’re in the 22% tax bracket, the amount you can invest is $780.

With a 401k, you can invest the entire $1,000 because you don’t have to pay income taxes on the earnings, at least not yet.

Using the taxable investment account and assuming a 7% average annual return, your $780 investment would grow to about $5,900 over 30 years.

Investing the entire $1,000 in your 401k would generate a balance of $7,600 over the same 30-year time period with the same 7% average rate of return.

Now imagine that you’re investing thousands of dollars in your 401k annually — for decades.

The difference in the two methods of investing can be worth tens of thousands of dollars or even hundreds of thousands of dollars by choosing the 401k.

Building wealth automatically

Since its inception, the S&P 500 has had an average annual return of about 10%. In the earlier example, we used a more conservative 7% return on a 401k investment.

This is because 401k plans have fees to cover administration and trading costs. It isn’t uncommon to lose 2% or more each year to various management fees.

If you invested $1,000 per month in your 401k, which can be a combination of your contributions and employer matching contributions, at 7% average annual return, you would have $1.1 million after 30 years.

If your average rate of return was 8%, you could save the same amount with only $800 per month.

Stretching the investment time frame to 40 years (age 21 to age 61), you can build a nest egg worth nearly $2.5 million with a $800 monthly contribution and an 8% average annual return.

Tax-deferred savings

Your 401k earnings are still taxable, but you’ll pay taxes only on the amount you withdraw and your savings can grow without a tax burden, often for decades.

When you reach age 59 ½ you can withdraw from your account without a penalty but it’s unlikely that you’ll need all the money you’ve saved at once. Maybe you’ve saved $1 million.

At age 70 ½, you’ll be required to begin making withdrawals — and paying taxes — if you aren’t still working for the company that sponsors your 401k.

The required minimum withdrawal is only about $37,000 at age 70 ½.

The remainder of your balance can continue to grow  tax-deferred if you don’t need it yet.

The IRS provides worksheets to help you calculate the required minimum distribution that begins at age 70 ½.

In most cases, you’ll be in a higher tax bracket during your working years, which means you’ll have a lower tax rate when you take your distributions during retirement.

Employer matching contributions

Many employers offer matching contributions, which are one of the most compelling reasons to participate in a 401k.

Matching contributions can follow many structures but a common formula is matching contributions of 50% up to 6% of your earnings.

If your employer uses this formula, you would benefit the most by contributing 6% of your income.

Your employer will contribute another 3% of your income under this formula, for a total of 9% of your income contributed to your 401k.

Income taxes are deferred on the amount contributed by both you and your employer.

It’s common for employer matching programs to follow a vesting schedule, which means the employer match part of your 401k may be limited until you’ve been an employee for 5 or 6 years.

One common structure is for vesting to follow a 5-year vesting schedule with the vesting amount increasing 20% each year until it reaches 100%.

Leaving the company before you are fully vested means you’ll sacrifice some of your 401k value that came from employer contributions.

Required Minimum Distributions

Both traditional 401k plans and Roth 401k plans have required minimum distributions beginning at age 70 ½.

The formula to calculate how much you’ll need to withdraw (and pay taxes on) can be complex and the amount changes based on your age and account balance.

Fortunately, Investor.gov provides a handy calculator to calculate your required minimum distribution.

Stiff penalties can apply if you don’t take out enough from your 401k (or IRA) when required.

If you are still working for the company that sponsors your 401k, you aren’t required to begin distributions until you retire or leave the company.

401k Loans

Many 401k plans offer a loan provision, which gives you some access to your savings — but with limits.

If your plan allows loans, you can borrow up to $50,000 or up to 50% of your vested account balance.

401k loans are repaid through payroll deductions over a 5-year period and you’ll pay interest on the loan — but you’re paying interest to your 401k account.

Unpaid loan balances, as may occur if your leave the company before the loan is repaid, are taxable as regular income and may be subject to an early withdrawal penalty.

Traditional 401k vs. Roth 401k

You’ve probably heard of a Roth IRA. About half of all 401k plans now offer a Roth 401k option, which has a similar structure to a Roth IRA but which has a much higher contribution limit.

Another important distinction is that your withdrawals from a Roth 401k before age 59 ½ are likely to incur a tax penalty.

With a Roth IRA, you can take your contributions back out as needed.

With a Roth 401k, you contribute after-tax dollars but your withdrawals are tax free — including the investment growth.

With a traditional 401k, you don’t pay income tax on your contributions or on employer matching contributions until you withdraw from your account.

Traditional 401kRoth 401kRoth IRA
Contribution
limit
$19,000$19,000$6,000
(subject
to income)
Tax
treatment
Tax
deductible
Taxable
as earned
Taxable
as earned
Withdrawal
tax
Taxable
as regular
income
Tax freeTax free
Withdrawal
age without
penalty
Age 59 ½Age 59 ½Age 59 ½
(Contributions
can be
withdrawn
at any time)
Required
minimum
withdrawals
Age 70 ½ Age 70 ½ At death

The table above provides a simplified comparison and includes Roth IRAs to highlight the distinctions between the three plans.

A Roth 401k can have two investment balances, each with its own tax treatment. Your own contributions, capped at $19,000 per year, are taxed as earned and can be withdrawn tax free.

If your company also contributes to your Roth 401k, these contributions are tax deferred and are subject to tax as regular income when you withdraw your funds in retirement.

A Roth IRA provides its largest benefit when compared to a traditional 401k if you expect to be in a higher tax bracket during retirement.

From another perspective, however, a Roth 401k eliminates future tax risk by paying taxes now — before investing.

We don’t know what tax rates will look like after 2 or 3 decades when you’re eligible to withdraw from a qualified retirement plan, but it’s safe to say they won’t be exactly the same as they are today.

How much can I contribute to my 401k?

Maximum contribution limits are revised regularly, which helps you to keep pace with inflation and wage growth as you invest in your 401k.

Currently, the contribution limit for individual contributions is $19,000 per year, up from $18,500 in 2018.

In most cases, this contribution limit applies to all of your defined contribution accounts combined. For example, if you also have a 403b account, the $19,000 limit applies to both accounts combined.

If you have a 401k and you have a traditional IRA, having both types of accounts can affect the deductibility of your IRA contributions but you can contribute to both accounts up to the individual limits of each account type.

The IRS also allows additional 401k catch-up contributions for those nearing retirement age.

Currently, you can contribute up to an additional $6,000 to your 401k if you are 50 or older.

In many cases, employers offer matching contributions as well. The IRS provides a separate limit that applies to the total of your own contributions and employer contributions.

Currently the annual defined contribution limit is $56,000 annually. Because 401k contributions are handled as payroll deductions, you also can’t contribute more than you earn.

For example, if you’re working part time earning $15,000 per year, you won’t be able to utilize the full $19,000 annual limit because your earnings are below the limit.

When can you withdraw from a 401k?

There is a 10% tax penalty if you withdraw from your 401k before you reach eligibility, which applies to the amount withdrawn in that tax year.

For most people, 401k withdrawals aren’t subject to the tax penalty after age 59 ½.

However, if you leave your job during or after the year of your 55th birthday, you can withdraw from your 401k without a tax penalty. Withdrawing before age 59 ½ is possible, but costly.

For example, if you withdrew $50,000 at age 45, you would pay a $5,000 tax penalty as well as paying taxes on the $50,000, which was tax deferred.

In some cases, 401k withdrawals can also push you into a higher tax bracket, compounding the cost of the withdrawal.

Generally, a loan against your 401k is preferable to a withdrawal — and loans from traditional lenders are usually an even better option because your 401k isn’t affected.

What are the tax benefits of a 401k?

401k plans don’t eliminate taxes. Instead, taxes on earnings are postponed until you withdraw from your 401k.

It’s useful to note that only income taxes are deferred when making 401k contributions.

FICA taxes, which include Social Security and Medicare taxes, still apply for each tax year.

By deferring taxes on part of your income, you’re paying less in taxes during your working years, which allows you to invest a greater amount.

Depending on your tax bracket, this means you may be able to put as much as 37% more money to work when compared to investing in a taxable investment account.

Most retirement savers are in the 22% tax bracket, however, which means they amount they may have available to invest through their 401k is 22% higher.

Most states don’t require 401k contributions to be included in taxable income, which can further increase the amount you have available to invest.

As your 401k value increases over time, the increase in value isn’t taxed as long as the funds remain in your 401k account.

Interest, dividends, and capital gains are all tax deferred and aren’t taxed until you withdraw funds from your account.

When you do withdraw, only the amount you withdraw is taxable.

For example, if your 401k is worth $500,000 and you withdraw $25,000 per year, you would pay taxes on the $25,000 you withdraw.

By contrast, in a taxable investment account, you would have less to invest because you have to pay taxes on earnings first.

Additionally, your gains may be taxable as your account builds in value.

Every time you sell a stock position or mutual fund in a taxable investment account, it creates a taxable event. Dividends are also taxable.

Taxes can create a headwind that slows investment growth in addition making tax preparation more complicated.

A 401k simplifies the process of investing for retirement.

Q&A about 401k retirement plan:

How much should I have in my 401k?

Your retirement needs will differ rather than use a fixed dollar amount, many experts recommend targeting a multiple of your current income.

Following this rule of thumb, at age 30, for example, your 401k and other retirement accounts should equal one year’s worth of income.

At age 40, target 3 year’s worth of income.

By age 50, five year’s worth of income becomes the target, and by age 60 when you are nearing retirement, you should have at least 8 year’s worth of income saved.

Bear in mind that income tends to increase with age and retirement income needs tend to be lower.

How much will my 401k be worth?

Ultimately, the value of your 401k account is based on investment performance after fees, how long you invest, and how much you invest.

As an example, if you invested $480 per month for 35 years and earned 8% annually, you’d have a million dollars at retirement.

Halving the investment amount to $240 per month also halves the value of your 401k to $500,000 over the same time period.

The biggest difference however, is usually compounding time. It pays to start investing early.

How long will my 401k last?

How long your retirement savings lasts depends on the amount you have saved as well as the annual return on your remaining funds and the rate of inflation.

A $500,000 nest egg will last 21 years if you’re earning 7% on the remaining balance and withdrawing $35,000 per year.

This example assumes a 3% inflation rate.

A million-dollar 401k balance bumps your retirement income up to $70,000 for 21 years, assuming the same rate of return and inflation rate.

How to cash out a 401k?

To begin taking withdrawals from your 401k, you’ll need to retire or leave the company.

You can roll your 401k over to an IRA to have more control over investment choices in retirement, and perhaps enjoy lower fees.

Rolling over your balance to an IRA doesn’t create a taxable event and you can withdraw as needed or in accordance with required minimum distribution rules.

How to rollover a 401k?

A broker or mutual fund provider can walk you through the process of rolling over your 401k.

In most cases, the money is transferred directly to a new or existing IRA account, which avoids any risk of a taxable event.

Proceeds from your 401k that aren’t transferred to another qualified retirement account within 60 days of leaving your 401k are considered as a distribution and are taxable as regular earnings.

How to borrow from a 401k?

Many plans support loans from your 401k, although there are some limitations. You can borrow up to 50% of your vested account balance up to $50,000.

Loans against your 401k are repaid with interest through payroll deductions over 5 years.

Your employer’s human resources department can coordinate the loan and set up the automatic payroll deductions.

Loan payments and interest are credited to your 401k account.

What happens to a 401k when you quit?

In many cases, you can leave the 401k with your former employer, although many people choose to roll 401k into an IRA instead.

By choosing to roll over the 401k balance to an IRA, you can continue to make contributions if needed.

You may also find management fees to be lower and more investment choices available with an IRA account. An IRA has a lower annual contribution limit, however.

How long do I have to rollover my 401k from a previous employer?

If you have enough money invested — usually about $5,000, most 401k plans allow you to leave your 401k account in place.

However, if you cash out your 401k and take possession of the funds, you’ll have 60 days to roll the funds over to another qualified retirement account.

After 60 days, the funds may be considered a disbursement and may be taxable.

How much is taxed on 401k early withdrawal?

The amount of the withdrawal is subject to a 10% early withdrawal penalty and also becomes taxable as regular income. In most cases, both federal and state income taxes must be paid on the amount that was withdrawn early.

What happens to 401k when you die?

When you start your 401k, you’ll be asked to name a beneficiary for your plan in the event of your death.

Some plans will allow your beneficiary to leave the funds in the 401k but in most cases, the funds will be distributed to your beneficiary in a lump sum.

Your beneficiary can then roll the amount over to an IRA within 60 days to avoid paying taxes on the amount before they are ready to withdraw the funds.

Take advantage of a 401k plan for your retirement

The biggest advantages of using a 401k for retirement savings are the high contribution limits and the employer matching contributions.

If your employer offers matching contributions, that alone is often enough reason to participate in the 401k plan because matching contributions are a guaranteed return on investment.

If your employer doesn’t offer matching contributions and you can’t afford to make a large contribution each year, an IRA may be a better choice in the interim because fees are often lower and you’ll have a wider choice of investments.

Of course, you might be able to use both types of accounts and diversify your retirement investments while giving yourself more investment choices.

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