What is a 401(k) Plan? Planning for Your Retirement

For most people, retirement is the most expensive financial goal they’ll save for in their life. According to the U.S. Department of Labor, you’ll need around 70% to 90% of your pre-retirement income to maintain your standard of living in retirement. That can require an investment portfolio worth upwards of a million dollars.

Luckily, you don’t have to save all that money by yourself. Instead, you can invest your money and let it grow on its own through the power of compound interest. Investing in your future can benefit you in the present as well. Many employers offer 401(k) plans, which are tax-advantaged investment vehicles that allow workers to save for retirement while also reducing their current tax burden.

According to data from the Bureau of Labor Statistics, roughly 64% of private industry workers have access to a defined contribution retirement plan like a 401(k) in 2020. If your employer offers a 401(k) plan, here’s why you should take advantage of it — and what to know before you start contributing. 

What Is a 401(k) Plan?

A 401(k) is a type of retirement plan that many employers offer to help their employees save and invest for retirement in a tax-advantaged way. The plan gets its name from the section of the tax code where it’s allowed.

“A 401(k) is an employer-sponsored retirement plan that gives you a tax break when compared to a taxable brokerage,” says Shang Saavedra from Save My Cents. “They come in two flavors — most people have access to a traditional 401(k), and some people can pick between a traditional versus a Roth 401(k),” she says.

A 401(k) is just one of a handful of tax-advantaged retirement savings vehicles available. Other options include an individual retirement account (IRA) for self-managed retirement savings, a 403(b) for public school employees and tax-exempt organizations, a 457(b) for state and local government employees and some non-profit employees, and a TSP for federal government employees.

How 401(k) Plans Work

A 401(k) is a benefit that many companies offer their employees, and it’s only available to those workers whose employers choose to offer it. If you have access to a 401(k), you can choose to contribute a percentage of your wages every year, known as elected deferrals. The maximum yearly contribution amount is set by the IRS and changes every year. If you’re age 50 or older, you’re also allowed a catch-up contribution of a set amount beyond the basic limit. In 2021, the basic limit on elective deferrals is $19,500 and the limit for catch-up contributions is $6,500. 

In most cases, contributions to 401(k) plans are excluded from your taxable income. 

A 401(k) is considered a defined-benefit plan, meaning your employer can choose to match a portion of your contributions, usually up to a certain percentage of income.

“These plans use automatic contributions from your paychecks to fund the account,” Saavedra says. You can choose how much of your paycheck you’d like to put towards your 401(k). The amount is automatically deducted from each paycheck and moved into the account as cash. You can then log into your 401(k) account and direct where you’d like the money to be invested, she says. 

When you sign up for your company’s 401(k) plan, you’ll likely be given a number of investment options. Common 401(k) plan investment options include exchange-traded funds (ETFs) and mutual funds, such as target-date funds that invest in appropriate investments based on the year you plan to retire.

The money in your 401(k) grows throughout your working life. Then, you can withdraw the money after the age of 59 ½ and pay income taxes on your withdrawals.

Withdrawals From a 401(k)

401(k) plans are specifically intended to help workers save and invest for retirement. As a result, you generally must be at least 59 ½ years of age to withdraw from your account, according to the IRS. Most withdrawals before that age will result in an additional 10% penalty on top of the income taxes you’ll pay.

Not only is there a limit to how soon you can withdraw from your 401(k), there’s also a limit to how late you can withdraw your money. The IRS requires individuals to take required minimum distributions from their retirement accounts starting at the age of 72, even if they haven’t retired yet.

There are some situations where you can make withdrawals before the minimum age. Here are some of the most common situations where you can withdraw from your 401(k) before the age of 59 ½:

Financial hardship

The IRS allows individuals to withdraw money from their 401(k) plan in the case of an “immediate and heavy financial need.” In this case, you can only withdraw up to the amount required to satisfy the financial need, and you may need to show that you can’t reasonably obtain funds from another source. Hardship distributions are subject to income taxes and may be subject to the additional 10% penalty on early distributions. 

401(k) loan

You can borrow money from your 401(k) plan without being subject to taxes or the early withdrawal penalty, provided your plan offers a loan option and the loan meets certain requirements, according to the IRS. In most cases, you can only borrow 50% of your balance or $50,000, whichever is less. You must also repay the loan within five years or as soon as you leave the company.

Rule of 55

“Beyond the dire straits option, a lot of people don’t realize you can access your 401(k) at 55,” says Delyanne Barros of Delyanne the Money Coach. The rule of 55 applies to workers who leave their jobs during or after the calendar year in which they turn 55. This includes anyone who is laid off, fired, or quits their job. “If you’re working at your current employer and are looking to retire, you can start to withdraw at 55,” says Barros.

Roth conversion

A less conventional option to withdraw money early from your 401(k) plan is through a Roth conversion. Roth conversion ladders are a popular move with those in the FIRE (financial independence, retire early) movement, according to Barros.

Using a Roth conversion ladder, you can roll the money over from your traditional 401(k) to a Roth account. Once the money has been in your Roth account for five years, you can withdraw it without paying income taxes or a penalty.

Keep in mind that converting money from a traditional to a Roth account is a taxable event, and you’ll pay income taxes on any money you roll over.

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

A traditional 401(k), which is the most common, allows you to contribute pre-tax dollars to your retirement account. Then, during retirement, you’ll pay income taxes on your withdrawals.

A Roth 401(k) is a similar account, but the tax advantage comes at a different time. With the Roth account, you contribute after-tax dollars. Then, you can make tax-free withdrawals during retirement.

One of the biggest considerations for choosing between a traditional and a Roth 401(k) is your tax bracket and where you think it’ll go in the future. For those at the beginning of their career, their income — and tax bracket — will likely increase in the future. For those people, “take advantage of the Roth 401(k) today when your tax bracket is low,” Barros recommends. But for high-income earners in a higher tax bracket, it might make more sense to take the deduction today and pay the taxes during retirement when your taxes are lower.

“It’s not a forever decision,” Barros adds, “you can change your mind at any time. 

If you really can’t decide between the two, Barros points out that you can always split your contributions between a traditional and Roth 401(k) and take advantage of both tax benefits.

What to Do When You Leave Your Job

When you leave your job, the one thing you shouldn’t do with your 401(k) is cash it out, says Barros. “Cashing it out means you’ll be hit with that 10% penalty and pay taxes on it, assuming it’s a traditional 401k. You’re really hurting yourself when you do that,” she explains.

When you leave a job, you’ll have several options for what to do with your 401(k) plan. First, you may be able to leave your money where it is. Many companies will continue to manage the 401(k) plans for former employees. And while you won’t be able to contribute anymore, your investments can continue to grow.

While this is an option available to many workers, Barros recommends against it. As you move throughout your career, it can be easy to lose track of your past 401(k) accounts. 

Instead, you can roll your 401(k) balance over to your new company. Many employers allow you to transfer a 401(k) balance from a previous plan. Once the money is with your new company’s plan, you’ll choose new investments and can continue to contribute. Rolling your account over to another plan allows you to keep tabs on all of your investments more easily.

You can also choose to roll your 401(k) balance into an IRA, which is a type of self-managed retirement plan. You can roll it into an existing IRA or open a new IRA with a bank or brokerage firm. If you roll the money from a traditional 401(k) into a traditional IRA, then the move doesn’t count as a taxable event. If you roll the money from a traditional 401(k) to a Roth IRA however, you’ll pay taxes when you convert the funds.

In some situations, if you decide to roll your 401(k) balance over into either your new 401(k) or an IRA, your previous employer may send you a check with the balance. According to the IRS, you have 60 days to deposit the check into another retirement account before you have to pay taxes and the 10% penalty on the money.

401(k) FAQs