how do 401k plans work
Investing | Retirement Planning

How Do 401(k) Plans Work?

A 401(k) is an employer-sponsored retirement plan that allows employees to dedicate a percentage of their salary to a retirement account. A 401(k) is a broader feature of an employer profit-sharing plan. Ideally, an employee elects the desired amount to contribute through an automatic payroll withholding, and their employers can match some or all of those contributions.

Most companies offering these plans have a set of eligibility requirements that one must meet. In most cases, you must be at least 21 years of age, be a full-time employee, and have accrued at least a year of service.

If you are already enrolled in a 401(k) plan — or plan to in the future — you’ll be thrilled to know that a 401(k) plan gives you tax breaks on all your contributions. Depending on your plan, the tax breaks either come when you contribute money or when you withdraw it in retirement. The cherry on top is, there’s free money involved – more on that below!

In this guide, we’ll help you understand what a 401(k) is and how it works so you can make confident decisions about your retirement options and get the most out of your retirement savings account.

Let’s get started!

What is a 401(k) plan and how does it work?

401(k) plans are named after a section of the U.S. Internal Revenue Code that created these plans in 1978. A 401(k) allows you to contribute a certain amount from your paycheck into a 401(k) retirement plan. This money is usually untaxed.

The funds in your account are then invested into a number of investment vehicles, including stocks, bonds, mutual funds, or other assets. Unlike other investments, funds on a 401(k) plan are not taxed on any capital gains, interests, or dividends until they are withdrawn, usually when you turn 59.5 years.

But what does this mean for you?

Typically, when you earn money, an income tax is automatically withheld on your paycheck. A 401(k) plan allows you to take an allowable percentage of your salary and put it in the plan to use in your retirement years. This salary deferral contribution and any earnings gained from this investment are exempt from tax. So, in short, you don’t pay taxes on the money until you withdraw it.

Additionally, 401(k) contributions are not considered as income. Why? Because these contributions are drawn out of your paycheck before the IRS takes their cut. This may place you at a lower tax bracket, allowing you to save on tax bills.

For instance, if you have an annual income of $65,000 and choose to defer $19,500 of your earnings through a 401(k) plan, you’ll only owe income taxes on the remaining $45,500 of your salary (instead of $65,000). In the end, you save massively for having squirreled away money for your later years.

How a 401(k) works

401(k) plan is an employer-sponsored investment plan. It is available in many workplaces as a benefit to employees. The 401(k) plan is perhaps the easiest and the most widely used way to start saving for retirement. When hired for a new job, your employer will give you some 401(k) paperwork to fill, whereas others may require you to wait until you finish your probation period.

When you enroll, you’ll set a certain percentage that you’d like to contribute from your salary. This contribution limit sits at $19,500, but your employer may cap the amount below that. People over 50 can contribute an additional $6,500 a year to help them catch up before their retirement. You can take advantage of this increased limit to boost your savings, even if you’ve been contributing to your 401(k) through the years.

401(k) matching contributions

One significant benefit of 401(k) plans is that many employers will make contributions to match what you have saved. While this is not mandatory, most employers have some matching plans, which can be dollar for dollar, 50% for each dollar, or other predetermined percentages up to a certain dollar amount.

Through employer matching contributions, you’ll be getting free money for every contribution you make. That’s a nice benefit you don’t want to miss out on. It, therefore, makes sense to make 401(k) contributions to take full advantage of the employer matching incentive.

What are the biggest benefits of a 401(k)?

401(k) plans offer many benefits to employees. Some of these include:

Tax benefits

This is perhaps the most powerful advantage of 401(k) plans. First, your 401(k) contributions are deducted before taxes, so you pay less in income tax. Also, as your 401(k) grows, you don’t pay taxes on those gains and will only pay for taxes when you begin to withdraw the money at age 59 . This allows your money to grow more quickly by compounding year after year.

Automatic long-term savings

Let’s face it, most people have trouble saving. The 401(k) plan allows you to take some percentage of your salary and save it for your retirement through automatic payroll deductions.

Employer matching contributions

If your employer offers a matching contribution, you’ll basically be getting free money. A typical example of a program includes an employer matching 50% of your contribution, up to 6% of your salary. If you are not contributing to a 401(k), you are leaving that money on the table.

High contribution limits

At age 50, you can enjoy higher contribution limits to boost your retirement benefits.

Easy payroll deductions

401(k) has an easy and efficient automatic payroll deduction process, allowing you to save early and contribute consistently to your retirement plan.

Contributions after age 72

Unlike some retirement accounts, which limit contributions after 72, 401(k) allows you to continue to contributing for as long you’re still working

Shelter from creditors

The 401(k) plan is protected by the Employee Retirement Income Security Act (ERISA), which protects you from judgment creditors.

You are in control

You get to choose how much (or little) you want to contribute to your account. 401(k) also gives you the flexibility to change your contribution levels at any time, depending on your situation.

What’s the difference between traditional and Roth 401(K) plan?

When setting up your retirement account, you can choose to set up a regular or traditional 401(k) or Roth 401(k) account if your employer allows it. These two retirement savings accounts vary in how they are taxed.

Roth 401(k) are a hybrid, blending the best parts of 401(k) and Roth IRAs to give employees various options when planning for employment. Both Roth 401(k) and traditional 401(k) plans allow employer matching of the paycheck contributions.

So, how are the two plans different?

In a traditional 401(k), employees contribute to their retirement accounts before the IRS taxes the income. This pretax arrangement reduces your current income tax bill significantly. However, when withdrawing your money at retirement, you’ll need to pay regular income tax.

On the other hand, if you choose to contribute to a Roth 401(k), you’ll receive no tax benefits for your contribution. This means that your income will first be taxed then you can contribute the after-tax dollars to your designated Roth account. However, unlike traditional 401(k), any money withdrawn from the Roth 401(k) account will be tax-free subject to the following criteria:

  • You’ve had the account for at least five years
  • You have attained the retirement age of 59.5 years or are eligible for disability benefits

Can you lose money in a 401(k)?

401(k) plans are an important part of retirement planning, but they are not perfect. Even with a well-thought-out strategy, it is still possible to lose money in a 401(k).

First, 401(k) funds are invested through various investment vehicles such as stocks and bonds. If you have some of your 401(k) contributions invested in stocks, your investment may lose money when the stocks tank. However, history has shown that bearish stock markets eventually rise again. So, the secret is in sitting it out long.

You could also potentially lose your 401(k) when changing jobs or become relieved of your duties. But there are several precautions you could take to avoid losing all your money. These include:

  • Rolling your 401(k) plan into an IRA
  • Rolling the 401(k) into a new employer’s plan if allowed
  • Leaving the money in the 401(k) of your former employer
  • Cashing out

While cashing out looks like an easy option for many people, you could potentially lose hundreds of dollars in taxes and penalties. This can be a massive hit on your savings. So what should you do with your 401(k) from a previous job?

The smart option is rolling it over into an IRA. Now, to expound on this, we will look at these two scenarios:

Suppose you’ve invested $10,000 in a 401(k) plan but need to change jobs or have unfortunately lost your job. If you are in the 24% tax bracket, cashing out, your account will attract a 10% withdrawal penalty and a withholding tax on your $10,000. In the end, you’ll just be left with $6,600 after taxes and penalties.

Now, suppose you decided to roll that $10K over to an IRA and let it sit for 30 years. Your savings can grow up to $267,000.

This shows how easy it is to lose money with 401(k) since even a tiny cash out has a significant impact on your savings. Yet, with the right investment decision, you can grow your investment tenfold.

How about taking a 401(k) loan?

This is another appealing option that could possibly lead to a loss of money invested in your 401(k). The IRS has strict regulations guiding how employees can utilize their 401(k) savings to take up a loan.

While the 401(k) loans allow you to use your retirement savings without paying taxes or penalties, doing this has a bunch of things that can go wrong really fast.

  • First, your contributions to the 401(k) plan are usually pre tax. However, when you take up a 401(k) loan, you’ll be required to pay it back after dollars. This eats up into your income and takes you significantly longer to pay up the same amount.
  • You’ll have to pay up the amount drawn plus the interest
  • 401(k) loans should be paid within a specific time frame. If, for some reasons, you fail to clear this loan, you’ll have to pay additional taxes and penalties that can negate all the gains you’ve made with your 401(k)
  • Your 401(k) loan will be due within 60 days if you leave your job for whatever reasons.

401(K) retirement plan withdrawals

Ideally, the 401(k) plan is tailored to help you save for retirement, thereby safeguarding your financial health in retirement. As such, it is not easy to withdraw these retirement savings. 401(k) withdrawals have strict rules and regulations to discourage you from withdrawing the money.

To withdraw money from your 401(k), you must meet specific criteria called “triggering events.” These include:

  • You become disabled
  • You retire
  • You die
  • You reach age 59
  • Your 401(k) plan is terminated

What is the U.K. Equivalent of a 401(k)?

In the U.S., traditional 401(k), Roth 401(k), and IRA are tax-efficient retirement saving vehicles. The U.K. equivalent to these retirement savings accounts is U.K. pension schemes such as SIPPs, personal pension, and stakeholders.

But perhaps the plan that comes closest to U.S. 401(k) is the SIPP – Self-Invested Personal Pension. This U.K. equivalent of 401(k) is a tax-efficient retirement savings account where employees can voluntarily allocate a percentage of their salary/asset into a range of investments, including:

  • Bonds
  • Stocks
  • Mutual funds
  • Exchange-traded funds (ETFs)

The only difference? With 401(k) plans, the employer chooses the investment vehicles to use while SIPP relies on investments approved by the country’s Her Majesty’s Revenue and Customs (HMRC).

ISAs or individual savings accounts are the U.K. equivalent of U.S. IRA (Individual Retirement Accounts).

Final thoughts

A 401(k) plan is a good retirement savings account. These plans are easy to set up and have simple automatic paycheck withholding to help you save for your retirement. With a 401(k), you’ll lower your tax bill significantly while still keeping pretax dollars for your retirement.

The crown jewel of these plans is the employer matching programs. Most employers will match your contributions in full or by a percentage up to a certain dollar amount. This is free money that can go towards your retirement, allowing you to build a fluffy cushion of cash when you retire.

If you haven’t saved anything towards your retirement, now is the time to do so. Don’t wait any longer! Consult with a financial adviser to help you choose a 401(k) investment strategy that fits your risk tolerance and long-term goals.