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

Point of Interest: 401(k) Plans

If your employer offers a 401(k), taking advantage of the associated tax benefits is usually a wise move. However, make sure you understand how 401(k)s work, what type is best for you and the implications for your taxes.

Employees looking to plan for retirement should consider investing in a company-sponsored, tax-advantaged 401(k) retirement account. Regularly touted as an employment perk during the hiring process, these plans offer an effective and often under-utilized way to prepare for you and your family’s later years in life. But what is a 401(k) and how does a 401(k) work? Understanding how a 401(k) works, how to maximize your advantages and how to get started today are paramount to proper retirement planning.

What Is a 401(k)?

401(k)s are company-sponsored retirement accounts that come in multiple forms. With all types of plans, employees make regular contributions from their paychecks into these retirement investment accounts. A 401(k) can be self-managed, managed by a company-appointed advisor, or overseen by an investment professional. As an added employee perk, some companies will offer percentage matching for the amount put into a 401(k), allowing employees to grow retirement savings at a much faster rate.

As these plans offer lucrative tax benefits, there are annual contribution limits. Before the age of 50, you’re able to contribute up to $19,000 annually. Keep in mind this number does increase yearly to keep pace with the consumer price index (CPI). If you’re over the age of 50, you can contribute an additional $6,000 annually, which is commonly referred to as a catch-up amount.

Be aware these limits do not take into account any employer-matched funds meaning those with generous employers have the option to see their 401(k)s grow by larger amounts annually. Current caps on the total annual contribution including employer match are $57,000 for those under 50 years of age and $63,500 for those over 50 years of age. These limits do not have any effect on other retirement investment products and contributions.

The key to understanding how 401(k)s work and why they are so popular has a lot to do with the associated tax benefits. Traditional 401(k)s are classified as tax-deferred, which means you won’t pay any taxes on that money until you withdraw it. If you’re planning on being in a lower tax bracket after retirement, this could spell huge savings. Additionally, this lowers your current yearly income which lowers your current overall tax burden.

For those planning on being in a higher tax bracket after retirement, you’re not out of luck. Roth 401(k)s, created in 2006, allow you to pay taxes on your contributions at your current tax rate and no taxes when you utilize the money later in life.

Calculating the amount of money you need for retirement is contingent on many factors. The most important factors include the age at which you plan to retire, your expected expenses, projected tax liabilities, potential retirement income and eligibility for social security and other government assistance programs. While the most accurate figure here will come from a professional, you can get a good general idea of your target needs by using a retirement calculator.

401(k) Alternatives

For those employed with companies offering 401(k)s and fund matching, retirement planning is straightforward. But what about those who are self-employed, not currently working, or working a minimum-wage job that might not allow the flexibility to make contributions?  You have options.

Some of the most popular options for those in these situations are IRAs, solo 401(k)s or a defined benefit plan. Each of these alternatives has pros and cons that are important to weigh and compare to your unique situation. Remember, even the least ideal retirement savings plan is better than no retirement savings plan.

Using 401(k) Funds

Knowing how to contribute and manage are only the first two steps of understanding how a 401(k) works. The final and arguably more exciting step is understanding how to utilize the funds that you’ve saved. For most, this will come upon retirement. Depending on your age and the type of plan you have, you’ll have different options.

After the age of 59 ½, you can begin withdrawing from your 401(k) without any penalties for early withdrawals. Depending on the type of plan, you’ll have the option of taking your funds as a lump sum, non-periodic withdrawals or with regular distributions as an annuity. You’re not required to begin taking disbursements if you don’t need them yet, but you will not be able to contribute anymore unless you convert your 401(k) into an IRA.

There are two important exceptions to this. First, if you have less than $5,000 in your account, it will be paid out in a lump-sum or rolled over into an IRA if the company forces you out of your plan. Second, once you hit the age of 70 ½, you will need to start taking minimum distributions by April 1 of the following year. You do have the potential to delay this if you are still working.

For those that need access to their funds early, you have options. If you’re 55 years or older and have recently retired or lost your job, you’ll be able to access your 401(k) immediately without the 10% early withdrawal penalty. Keep in mind this only applies to your most recent job and 401(k) retirement account. Any accounts from previous jobs will be subject to the early withdrawal penalty if you don’t wait until you are 59 ½.

You can access your funds before the age of 55 through hardship withdrawals or by taking out a 401(k) loan. Hardship withdrawals are capped at the amount required for the hardship and do require demonstration of an immediate need. These withdrawals also come with a 10% early withdrawal penalty. 401(k) loans, on the other hand, are capped at $50,000 or 50% of your account balance, whichever is less.