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.
Loans
Some 401(k) plans permit loans up to 50% of the account balance up to $50,000. Loans have repayment terms and interest is charged. Defaults are treated as distributions, subject to taxes and penalties.
Portability
Leaving an employer allows one to rollover the 401(k) balance to an IRA or to the new employer’s 401(k). This preserves the tax-advantaged status of the funds.
401(k) plans help American workers save and invest for retirement in a tax efficient manner. Understanding the fundamentals allows participants to maximize the features and get closer to their retirement goals.
A 401(k) is a retirement savings plan offered employers in the U.S. It allows employees to contribute a portion of their pre-tax salary to the plan, and these contributions grow tax-deferred until withdrawal in retirement. Employers may match a percentage of the employee’s contributions. Withdrawals are typically taxed when taken, and there may be penalties for early withdrawals before age 59½. It’s a common way to save for retirement with potential tax advantages.
A 401(k) plan is a retirement savings plan offered many American employers that has tax advantages for the saver.The employee who signs up for a 401(k) agrees to have a percentage of each paycheck paid directly into an investment account. The employer may match part or all of that contribution.