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What is a 401(k) plan and how does it work?
A 401(k) is a retirement savings and investing plan that employers offer. A 401(k) plan gives employees a tax break on money they contribute. Contributions are automatically withdrawn from employee paychecks and invested in funds of the employee’s choosing (from a list of available offerings). 401(k)s have an annual contribution limit of $20,500 in 2022 ($27,000 for those age 50 or older).
The catchy name comes from the section of the tax code — specifically subsection 401(k) — that established this type of plan. Employees contribute money to an individual account by signing up for automatic deductions from their paycheck. Depending on the type of plan you have, the tax break comes either when you contribute money or when you withdraw it in retirement.
If this is the point at which you dozed off during employee orientation, you missed the best part — and that's especially the case if there's free money involved (more on that below).
How do you get a 401(k)?
You get a 401(k) from your employer. Unfortunately, not all employers offer access to a 401(k) plan. Don't despair if you fall into that camp. You can still reap the same tax benefits from the other big retirement savings vehicle, an individual retirement account.
All that may raise the inevitable question: What is an IRA? These accounts offer some attractive benefits (a broader selection of investments and generally lower fees), albeit with a few downsides (lower contribution limits and restrictions for high earners). Here’s how a 401(k) differs from an IRA and, if applicable, how to take advantage of both at the same time.
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What’s in it for you
Many employers offer to match a portion of what you save. The 401(k) perk that gets all the headlines is the employer match. If you work somewhere that offers to toss extra money into your account based on how much you contribute — for example, a dollar-for-dollar or 50-cents-on-the-dollar match up to, say, 6% of your contribution amount — stop reading now and fill out the sign-up paperwork. If you do nothing else, at least contribute enough to your account to nab that free money.
Play around with our 401(k) calculator to see how your savings will grow with a 401(k) — and the difference incremental changes, including any company match, will make over time.
This is a good time to mention there are several types of 401(k) plans, including the two main kinds: the traditional 401(k) and the Roth 401(k). The traditional (or regular) 401(k) offers upfront tax break on your savings. Contributions to a Roth 401(k) are made with after-tax dollars, so you don’t get to deduct the money from that year’s taxes. But don’t worry; the Roth's payoff comes later.
Pretax contributions make saving a little less painful. Contributions to a traditional 401(k) plan are taken out of your paycheck before the IRS takes its cut, which supersizes each dollar you save. Let’s say Uncle Sam normally takes 20 cents of every dollar you earn to cover taxes. Saving $800 a month outside of a 401(k) requires earning $1,000 a month — $800 plus $200 to cover the IRS’ cut. When they — whoever the “they” is in your life — say that you won’t miss the money, this is what they’re referring to. (Here are the contribution limits to shoot for this year.)
Contributions can significantly lower your income taxes. Besides the boost to your savings power, pretax contributions to a traditional 401(k) have another nice side effect: They lower your total taxable income for the year. For example, let’s say you make $65,000 a year and put $19,500 into your 401(k). Instead of paying income taxes on the entire $65,000 you earned, you’ll only owe on $45,500 of your salary. In other words, saving for the future lets you shield $19,500 from taxation.
Investments in the account grow unimpeded by Uncle Sam ... Once money is in your 401(k), the force field that protects it from taxation remains in place. This is true for both traditional and Roth 401(k)s. As long as the money remains in the account, you pay no taxes on any investment growth. Not on interest. Not on dividends. Not on any investment gains.
... at least for a while. The tax-repellent properties of the traditional 401(k) don’t last forever. Remember when you got that tax deduction on the money you contributed to the plan? Well, eventually the IRS comes back around to take a cut. In technical terms, your contributions and the investment growth are tax-deferred — put off until you start making withdrawals from the account in retirement. At that point, you’ll owe income taxes to Uncle Sam.
Here’s where the Roth 401(k)’s superpower is revealed.
A Roth 401(k) gets the taxes out of the way, right away. The Roth 401(k) offers the same tax shield on your investments when they are in the account; you owe nothing to the IRS on the money as it grows. But unlike with qualified withdrawals from a regular 401(k), with a Roth you owe the IRS nothing when you start taking distributions.
How’s that, exactly? Remember we mentioned earlier that, depending on the type of 401(k) plan, you get a tax break either when you contribute or when you withdraw money in retirement? Well, the IRS can charge you income taxes only once. With a Roth 401(k), you’ve already paid your due because your contributions were made with post-tax dollars. So when you withdraw money in retirement, you and Uncle Sam are already settled up.
» Still not sold on investing? Learn how inflation can impact your savings — and how investing can boost it — with our inflation calculator.
You can take it with you
If you leave your job someday for another, you can (and should) take your 401(k) with you. This won't go into a box with your other belongings; rather, you'll need to roll over that account into a new one — and for many people, converting that 401(k) to an IRA is a great idea. You'll want to consult our guide for 401(k) rollovers when that time comes.