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What Is A 401(k)? How Does It Work?

9 min read

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A 401(k) is a retirement plan many workers are offered through work that gives you lots of tax incentives to save for their retirement. The funky name comes from the part of the Internal Revenue Code that defines the rules and regulations for these accounts. A 401(k) is what is also known as a defined-contribution…

A 401(k) is a retirement plan many workers are offered through work that gives you lots of tax incentives to save for their retirement.

The funky name comes from the part of the Internal Revenue Code that defines the rules and regulations for these accounts.

A 401(k) is what is also known as a defined-contribution pension plan. For public sector workers and non-profits, their version of defined contribution plans are known as 403(b) plans and 457 plans. The Thrift Savings Plan for federal government employees is another type of defined contribution plan.

The basic rules and strategies are the same across the different types of defined contribution plans. Given the importance of saving for retirement, understanding how a 401(k) – or other defined contribution plan – works will help you build retirement security.

You have your own personal account within a 401(k) plan. When you are enrolled in a plan, you receive your own account where you are in control of how much you save, and how the money is invested.

A couple of 401(k) terms you might come across: You are the plan participant. Your employer is the plan sponsor. And the financial service company that operates the 401(k) is called the 401(k) administrator.

There are two types of 401(k)s: Traditional 401(k) and Roth 401(k). All employers offer a Traditional 401(k), and many also now offer a Roth 401(k). The big difference between the two is when you pay tax to Uncle Sam.

With a Traditional 401(k) your contributions are made with pre-tax salary, so you get an upfront tax break on your contributions. For example, if your salary is $80,000 and you contribute $8,000 to your 401(k), your taxable income drops to $72,000. All 401(k) money – whether it is in a Traditional or a Roth – is free of taxes for the time the money is invested. That’s what is known as tax-deferred savings. With a traditional 401(k), your tax bill comes in retirement: every penny you withdraw will be taxed as ordinary income. And even if you don’t want to make withdrawals, starting at age 70.5 you are forced to take required minimum distributions (RMDs), so the federal government can collect its tax.

Contributions to a Roth 401(k) are made with salary that has already been taxed. That is, there’s no upfront tax break. You are essentially paying your tax bill upfront. Your tax break comes in retirement: you will not owe any tax when you make withdrawals. And you will not be required to take RMDs if at retirement you transfer your account from a Roth 401(k) to a Roth IRA. It’s easy to do, and there’s no tax bill when you do what is called an IRA Rollover from a Roth 401(k) to a Roth IRA.

While it can be tempting in the here-and-now to grab the upfront tax break on contributions to a Traditional 401(k), in retirement you may very glad you have a source of income that will not count as taxable income. Financial advisors increasingly suggest that having a mix of Traditional and Roth 401(k) money will give you important “tax diversification” in retirement.

You can toggle between saving in a Traditional or a Roth; you just need to tell your plan where you want your contributions to go.

One caveat: Even if you opt for the Roth 401(k), any company match you are entitled to will be made into a Traditional 401(k).

The bulk of your savings will come from your salary. Your employer may contribute to your account—as an incentive to get you to save-but the bulk of your 401(k) savings will come from the money you take out of your paycheck and send into your 401(k) account.

The money you contribute from your salary is 100 percent yours from day one. You can quit your job a week after making a contribution and that money will always be yours.

Your contributions are deducted from your paycheck and are a percentage of your salary. When you sign up for a 401(k) or are automatically enrolled, your employer may set your contribution rate at 3 percent of your salary. That’s way too low. To build retirement security, financial pros recommend aiming to save 10 percent to 15 percent of your salary. It’s easy to raise your contribution rate; you likely just need to contact H.R. and fill out a form.

Your employer may kick in some money too. Many employers offer a matching contribution. Each employer can use its own matching formula. Your job is to understand how your plan’s match works and make sure that from day one you are contributing enough to get the maximum match. Some new workers who are automatically given a three percent contribution rate don’t qualify for the maximum employer match. That’s like turning down a bonus. Ask H.R. or the customer service for your plan on how your company’s match works.

Money from your employer match typically isn’t 100 percent yours…at least for a while. Many 401(k) plans have a “vesting schedule” for your match. If you leave your job—voluntarily or not—before your match has fully vested, you will lose the unvested portion. For example, one common vesting schedule is that one-third vests (becomes yours for keeps) each year. After three years, the match is yours. So if you left after one year, you would be entitled to keep one-third of last year’s matching contribution.

To be clear: what you contribute is always yours to keep. It is just the matching contribution that is tied to the vesting schedule.

You choose how to invest. Your 401(k) will include a menu of mutual funds or collective investment trusts (CITs) you can invest in. There will be stock funds, bond funds, funds that mix stocks and bonds. It’s up to you to decide how you want to split up your money. A popular option is the Target Date Fund that is offered by the majority of 401(k) plans. Pick a TDF with a year that corresponds to your expected retirement date and you will automatically be invested in a portfolio that owns a mix of stocks and bonds and cash deemed appropriate for your investment time horizon.

You can take your money out before retirement,  but it’s best to keep it growing. A feature of 401(k)s that is not available with an IRA is that you can take a loan from your 401(k). This should be considered only for emergencies. Once you take out money, you’ve lost the ability for that money to keep growing for retirement. Even when you eventually repay your account, you’ve still missed out on that period of growth. Moreover, when people are busy repaying what they borrowed they tend to not make new contributions. So you’re shortchanging yourself there. And it’s important to realize that if you leave your job—involuntarily or not—you typically must repay the loan within six months. If you don’t, the outstanding balance will be treated as a withdrawal. If you’re not yet 55 you will owe a 10 percent early withdrawal penalty, and if your loan was from a Traditional IRA you will owe income tax on all the money. With a Roth 401(k) you will owe the early withdrawal penalty and tax on any earnings (you won’t owe tax on the money you contributed.)

Outright withdrawals are also allowed whenever you leave a job. It can be tempting to cash out some money when you make a move. But this is hands down the worst retirement mistake you can make. In addition to the penalty and tax, you have just robbed yourself of future retirement savings. If you cash-out $10,000 today from a Traditional IRA and you’ll probably get less than $7,500 after the 10 percent penalty and income tax. If you left that money growing tax-deferred for another 30 years and it earned an annualized 6 percent it would be worth more than $57,000. That’s a lot of retirement security to pass up.

You can move your 401(k) money into an IRA. When you leave a job you typically have the option of leaving the money in the plan (unless your account is worth less than $5,000), or you can move the money to another retirement plan. Your new employer may allow you to move your old 401(k) into its plan. That may make sense if you are sure the plan at your new job has a terrific line-up of low-cost investments.

Another option is to transfer your 401(k) into an IRA at a discount brokerage. The advantage is that you no longer are limited to the investment options offered within your plan, you can choose among thousands of funds or individual stocks and bonds. That can make sense if your 401(k) doesn’t offer the lowest-cost funds. For example, you can now invest in index mutual funds and ETFs through discount brokerages that have annual expense ratios (the ongoing cost deducted from performance) as low as 0.10 percent, and in some cases there are ETFs with no expense charge  Those low fees are a big advantage if the investments in your fund charge high fees.

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Disclaimer: the content presented in this article are for informational purposes only, and is not, and must not be considered tax, investment, legal, accounting or financial planning advice, nor a recommendation as to a specific course of action. Investors should consult all available information, including fund prospectuses, and consult with appropriate tax, investment, accounting, legal, and accounting professionals, as appropriate, before making any investment or utilizing any financial planning strategy.

About the author

Carla Fried

Carla translates business and personal finance concepts into engaging content that helps individuals make more confident choices in how they manage their money. Her work appears in The New York Times, Money Magazine, Barron's and Consumer Reports.

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