What Is a 401(k) and How Does It Work? 401(k) Basics

 

A 401(k) is one of the most popular employer-sponsored retirement savings plans in the United States. Here is a primer on what a 401(k) is, how it works, and key 401(k) features:

What is a 401(k)?

A 401(k) is an employer-sponsored, tax-advantaged retirement savings account. With a traditional 401(k), employees can make pre-tax contributions directly out of their paycheck into the 401(k) account up to an annual limit. The contributions and investment earnings grow tax-deferred until withdrawal.

Eligibility

Employees of companies that offer a 401(k) plan typically become eligible to participate in the plan after meeting certain criteria, such as being at least 21 years old and having worked at the company for a minimum of one year.

Contributions

With a traditional 401(k), employees can contribute up to $20,500 in 2022, with those 50 or older eligible for an extra $6,500 catch-up contribution. Total employee plus employer contributions cannot exceed $61,000 annually ($67,500 for those 50 or older).

Employer Matching

Many employers offer to match employee 401(k) contributions up to a certain percentage. For example, an employer might match 100% of contributions up to 3% of one’s salary and 50% for the next 2% of salary. This essentially provides free money towards retirement savings.

Investments

401(k) funds can be invested in a range of plan investment options like stock mutual funds, bond funds, target date funds and more. Participants choose how their contributions get invested.

Tax Benefits

Traditional 401(k) contributions provide upfront tax savings. They are made pre-tax, reducing current year taxable income. Taxes are only owed when distributions are taken in retirement. Earnings also grow tax-free over time.

Withdrawals

Withdrawals typically begin at retirement age rolling over to an IRA or taking periodic distributions. Withdrawals before age 59 1⁄2 incur a 10% penalty tax unless an exception applies. Required minimum distributions (RMDs) must begin at age 72.