The Essential 401(k) Guide: Pros, Cons and How They Work
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What is a 401(k)?
A 401(k) plan is an employer-sponsored retirement account. The two most common types are traditional 401(k) and Roth 401(k) plans, each having their own set of tax advantages.
"From both a savings and investment perspective, thoughtfully designed 401(k) plans make it easy for workers to stay on track for their retirement goals," Jeff Clark, head of defined contribution research at Vanguard, said in an email interview.
Employees contribute part of their paycheck to be invested in the account. While not required, many employers match a percentage of employee contributions. In 2023, the average contribution rate was 7.4%, and the average combined contribution for employers and employees was 11.7%, according to Vanguard's How America Saves 2024 report.
» Estimate your future balance with our 401(k) calculator.
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How does a 401(k) work?
When you enroll in a 401(k) plan, you’re agreeing to put a percentage of your paycheck into a retirement investment account. Some employers automatically enroll new hires into a 401(k) plan. Clark said 59% of Vanguard's plans now have auto-enrollment.
Employee contributions and employer matches, if offered, are invested, and the money grows tax-deferred until retirement. After enrolling in your 401(k) plan, you may be able to select your investments — typically target-date funds and other mutual funds — based on what’s offered by your employer’s plan provider.
According to the Investment Company Institute, 70 million people are actively participating in 401(k) plans, which hold $7.4 trillion in assets.
» More on how to invest your 401(k) plan
What are the types of 401(k) plans?
The two main types of 401(k) plans, Roth and traditional, are differentiated by their tax advantages. Depending on the type of 401(k) plan you choose, you could get the tax benefits when you contribute the money (traditional) or when you make withdrawals in retirement (Roth). While traditional 401(k) plans are more common, many employers now offer Roth 401(k)s as well.
Traditional 401(k)
Contributions to a traditional 401(k) plan are taken out of your paycheck before the IRS takes its cut, and your money grows tax-free.
Once you invest in the 401(k), the money is protected from taxation. This is true for both traditional and Roth 401(k)s. As long as the funds remain in the account, you pay no taxes on any investment growth: not on interest, not on dividends and not on any investment gains.
Besides the boost to your saving power, pretax contributions to a traditional 401(k) have another benefit: They lower your total taxable income for the year.
But the tax-repellent properties of the traditional 401(k) don’t last forever. Remember that tax deduction on the money you contributed to the plan? Eventually, the IRS comes back around to take a cut. Your contributions and the investment growth are put off until you start making withdrawals from the account in retirement. At that point, you’ll owe income taxes.
Traditional 401(k)s have one more caveat: after a certain age, account holders must takerequired minimum distributions, which aren’t required with a Roth 401(k).
Roth 401(k)
If your employer offers a Roth 401(k) — and not all do — you can contribute after-tax income and your withdrawals will be tax-free in retirement.
The Roth 401(k) offers the same tax shield as a traditional 401(k) on your investments when they are in the account: You owe nothing to the IRS on the money as it grows. But, unlike with withdrawals from a regular 401(k), with a Roth you owe the IRS nothing when you start taking qualified distributions as long as you are 59½ and have held the account for five years or more.
That’s because you’ve already paid your taxes since your contributions were made with post-tax dollars. And any income you get from the account — dividends, interest or capital gains — grows tax-free. When you meet the requirements for a qualified withdrawal, you and Uncle Sam are already settled up.
» Dive deeper: With our full explainer on traditional vs. Roth 401(k) plans.
How much can I contribute to my 401(k)?
In 2024, individuals can contribute up to $23,000 in 2024 ($30,500 for those age 50 or older). There are no income limits restricting who can contribute to a 401(k) plan.
If you're wondering how much you should contribute, many financial professionals say you should aim to contribute 10% to 15% of your income to retirement savings. According to Fidelity Investments, the average 401(k) contribution rate was 14.2%, in the first quarter of 2024, and that includes employer and employee contributions.
If 10% to 15% of your salary feels too steep, it's fine to contribute what you can and work your way up as you can afford to. You aren’t required to contribute the maximum, but’s a good rule of thumb to consider contributing enough to get your employer match if one is offered. » Learn more: How much should I contribute to my 401(k)?
What are the pros and cons of a 401(k)?
One benefit of a 401(k) plan is that it offers higher annual contribution limits than individual retirement accounts (IRAs). In 2024, the 401(k) plan max is $30,500 for those 50 and older in 2024. Meanwhile, an IRA tops out at $8,000 annually for those 50 and up.
Another pro is that many employers offer matching 401(k) contributions, which means free money going into your retirement account.
Some disadvantages of 401(k) plans are that they often offer a more limited selection of investments, and generally have higher fees than IRAs.
That said, you can have both an IRA and a 401(k) as part of your retirement strategy if you want.
» Interested in an IRA? See our picks for the best IRA accounts.
What are the 401(k) withdrawal rules?
To make a qualifying withdrawal from a traditional 401(k), you must be at least 59½, have a qualifying disability, or qualify for a hardship withdrawal. If you don't meet these requirements, you may face a 10% early withdrawal penalty, plus you'll have to include your withdrawal as part of your income when you file taxes.
As of January 2024, plan participants can withdraw emergency expenses of up to $1,000 per year without paying the 10% penalty. If the money isn't repaid within three years, however, no additional emergency distributions are allowed over those three years.
Still, in most cases, an early 401(k) withdrawal will still trigger taxes, and leave less money in the account to invest over time.
» Learn more about 401(k) early withdrawal rules
What are required minimum distributions?
Once you reach age 73, taking withdrawals from your traditional 401(k) stops being a choice. Required minimum distributions are the amounts you must take out of your 401(k) each year, unless you're still working and choose to defer until retirement.
You are allowed to withdraw more than the minimum, and the distributions are included as part of your taxable income for the year. If you have a Roth 401(k), there are no required minimum distributions.
What happens to my 401(k) if I quit my job?
If you leave your job, you can take your 401(k) money with you. You can choose to roll the money into a new employer’s 401(k) plan or into an IRA. Rollovers completed within 60 days usually are not taxable. You also could choose to leave it where it is in your old employer’s plan, but you can’t keep contributing to it.
» Ready to get started? See the best IRA providers for a 401(k) rollover.
Next steps:
Dive deeper into the IRA vs. 401(k) debate.
Learn about 401(k) taxes on contributions and withdrawals.
What to do if you overcontribute to your 401(k).
Explore the average 401(k) balances by age
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