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What Is a 401(k)?

Simone Johnson
Simone Johnson
Staff writer

A 401(k) is an important retirement savings vehicle that many employers offer to their employees. Here's what you should know about this type of plan.

A 401(k) is a retirement savings plan offered by employers and regulated by the IRS, with specifications on how much money employers and employees can contribute each year and how the funds are taxed. Read on to learn more about what a 401(k) retirement savings account is, how it works, how it's taxed and the contribution limits for 2020.  

What is a 401(k)?

The 401(k) retirement plan has been around since the 1980s and is named after its section in the Internal Revenue Code. This employer-sponsored plan allows employees to choose what percentage of each paycheck they contribute. That money is then taken out of their paychecks and deposited into an investment account. Employees direct how the funds are invested. 

Traditional vs. Roth 401(k)

There are two types of 401(k) plans that most investors can choose from, each with advantages and disadvantages. Speak to your financial advisor about what type works best for your current situation. According to the investment firm Charles Schwab, the timing of your investments usually dictates which type to use for retirement savings. In many cases, Roth 401(k) plans are recommended to younger investors, while traditional 401(k) plans are utilized by older investors. However, you don't necessarily have to choose one or the other. Instead, you may split your investment between both.

Traditional 401(k)

A traditional 401(k) is funded with pretax money. This means that the money is deducted from an employee's paycheck before taxes are taken out. The benefit of this method is that it lowers the employee's taxable earnings, which may reduce their current tax burden.  

The money won't be taxed until the employee withdraws it. The assumption is that the employee will be in a lower tax bracket once they retire, since they will no longer be earning a regular paycheck. 

The risk is that, as taxes continue to rise, the future tax rate may be higher than the current one, even for lower tax brackets. Employees will also be paying taxes on the interest they earned on their retirement investments. 

 

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Roth 401(k)

A Roth 401(k) is funded with money that has already been taxed, which means that the money is deducted from an employee's paycheck after taxes are taken out. The benefit of this method is that the employee won't have to worry about paying taxes on the money when they withdraw it, because it's already been taxed. An even bigger advantage of this type of 401(k) account is that the interest it earns isn't taxable. 

The risk is that employees may currently be paying a higher tax rate on the money than they would after they retire, since they will be in a lower tax bracket when they're no longer earning a regular paycheck. 

[Are you an entrepreneur looking for ways to save for retirement? Check out our article "The Solopreneur's Guide to Retirement Funds," which breaks down alternative savings plans for self-employed people. ]

How does a 401(k) work?

For employees, a 401(k) works similarly to a personal savings account. Let's say an employee is paid $100 a week and puts 20% of their check into a traditional 401(k) account. This means 20% of their pretax earnings are deposited into their retirement account. 

"The administrator puts that $20 into an investment portfolio, often a fund of some kind," said Bryan Kesler, certified public accountant and CEO of CPA Exam Guide. "That fund could be a big pile of money overseen by a fund manager, who invests it according to specific criteria." 

Employees may also be able to invest their money in stocks or bonds. 

What's a good amount to invest in a 401(k)?

There is no single answer to how much an employee should be investing in their 401(k). However, they should contribute enough to take full advantage of their employer's maximum matching contribution, Kesler suggested. 

Employees and self-employed individuals with solo 401(k) plans should also consider the kind of investment they want to make. If it's short term, they should invest a small amount; if it's long term, it would be more beneficial to add more. 

"Be aware of the fact that your money will be tied up for years to come, and adjust your contribution accordingly," said Ellie Thompson, CEO of Money Therapy

What are the 401(k) contribution limits for 2020?

For 2020, the contribution limit for a 401(k) is $19,500. For people 50 years old and older, the IRS allows a catch-up contribution of $6,500, which adds up to a possible contribution of $26,000. 

How much can a company contribute to an employee's 401(k)?

With most 401(k) plans, employers have the option to help their employees grow their 401(k) retirement funds by matching a percentage of their contributions. If the employer chooses a safe harbor 401(k), however, they are required to match or contribute to employee accounts (though employee contributions are still optional). Self-employed people with solo 401(k) plans can also make employer contributions to their accounts. 

This means that employers will contribute a certain amount to the savings plan, based on the amount of the employee contribution. For instance, the employer may contribute up to 25% of compensation for eligible employees, and with the exception of safe harbor plans, they may tie their contributions to a vesting schedule – which can encourage employee retention

There are two ways a company can match an employee's 401(k) contribution. 

Employer matching contributions

For this type of contribution, employers pick the percentage of the employee's contribution that they want to match. So, let's say a company agrees to a dollar-to-dollar match of up to 5% of an employee's salary. If the employee contributes 5% or more of their salary, the company will also contribute 5%. If the employee contributes a lesser amount, such as 3%, the company will also contribute 3%. 

According to Research Financial Strategies, 40% of companies contribute 50 cents on the dollar. So, for every dollar an employee contributes, the company matches with 50 cents. Most companies match an average of 2.7% of an employee's pay. The same study said that 38% of employers match employee contributions dollar for dollar. 

"You can't control whether your employer offers a match or the kind of match they provide," said Kesler. "But you'll be able to control how effectively you are taking advantage of the match they are offering. Taking full advantage of your employer match is one of the most important parts of maximizing your 401(k)." 

Employer non-matching contributions

For this type of contribution, the employer contributes a percentage of the employee's salary, regardless of how much – or even if – an employee contributes to their 401(k). 

"Some companies offer this kind of contribution additionally or instead of regular matching contributions," Kesler said. "It's important to note that these contributions aren't within the employees' control." 

Taking withdrawals from a 401(k)

Whether or not you can withdraw from a 401(k) early depends on a few factors. For one, your business must allow for early withdrawals. Not all companies permit employees to take an early withdrawal. However, business owners can tap into 401(k) funds at any time.

Although you may be able to withdraw the money, there are serious financial implications of using the funds prematurely. First, the IRS will likely tax you on your early 401(k) withdrawal at a rate of 20% of the full amount. For example, if you take $20,000 as an early withdrawal, the withholding from the IRS is $4,000.

Another consideration is the penalty based on your age at the time of withdrawing the funds. If you are under the age of 59.5 years, then the IRS charges a 10% penalty. Along with the 20% tax rate, you're likely to get 30% less than the full amount. For a $20,000 withdrawal, your take-home amount will be approximately $14,000.

In some cases, your tax responsibility can be reduced. For instance, if you claim an economic hardship, you may not have to pay the penalties, just the normal tax rate.  

To start the process of withdrawing from the 401(k), you have to contact the administrator of the fund. Most companies use a brokerage firm or bank to manage their 401(k) plans. After you contact the administrator and sign off on the withdrawal, funds usually take 3-10 days to be released.

How do I roll over my 401(k)?

The question many employees have when changing jobs is how to transfer money from one retirement plan to another. Employees have the option of a direct rollover, which has no penalties. This is when an employee rolls over their 401(k) account from their old job into their new employer's 401(k) plan. To roll over their account, an employee needs to take two main steps: 

  1. The employee should set up their new 401(k) account and call the plan administrator to get the account address.
  2. They should give this information to their old plan administrator. Account funds will then be directed from their old 401(k) to the new one. The money may be issued in the form of a check, which the employee must give to the new 401(k) administrator. 

Typically, the new employer will provide instructions on how employees can sign themselves up, usually by filling out an online form. If the employee isn't moving to a new job or doesn't want to move their 401(k) to their new employer's retirement plan, though, there are other options. 

The first option is to leave the money where it is. If the employee has more than $5,000 in their 401(k) account, they can keep the money in that fund, even if they no longer work for that employer. 

Another option is to directly transfer the money into an individual retirement account (IRA). When you transfer the funds directly, you avoid tax penalties. 

A final option is to cash out and do what you please with the money. However, there are some serious tax penalties for this. If you are under the age of 59 and a half when you cash out, you will be charged a 10% early withdrawal penalty. If it is a traditional 401(k) account, you'll also be charged income tax on the money. 

Can you lose money in a 401(k)?

You run the risk of losing money with any investment, and a 401(k) is no exception. For instance, if the economy enters a recession, people could lose some of their 401(k) savings. To mitigate potential losses, Kesler says you should diversify your funds as much as possible and find funds that have low expense ratios to lower your long-term risk. Don't panic if you see the stock market dipping, though. 

"Stay the course," said Steve Sexton, financial consultant and president of Sexton Advisory Group. "Your retirement account will be better off for it. If you are just a few years away from retirement, you might want to look at ways to reduce or eliminate your risk." 

How is a 401(k) taxed?

As mentioned above, contributions to a traditional 401(k) account usually come from pretax dollars, which means that the money is taxed when it is withdrawn. Roth 401(k) contributions have already been taxed, so they are not taxed again when the money is withdrawn. 

Account holders should be aware that once they retire, they can be penalized for not taking the required minimum distributions from their 401(k) accounts once they reach 72 years old.

Image Credit: Jacob Lund / Getty Images
Simone Johnson
Simone Johnson
business.com Staff
Simone Johnson is a business.com and Business News Daily writer who has covered a range of financial topics for small businesses, including on how to obtain critical startup funding and best practices for processing payroll. Simone has researched and analyzed many products designed to help small businesses properly manage their finances, including accounting software and small business loans. In addition to her financial writing for business.com and Business News Daily, Simone has written previously on personal finance topics for HerMoney Media.