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

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You’ve probably heard of a 401(k) retirement plan. You may even contribute to a 401(k) plan at work.

Even so, you may have questions such as, “What are the 401(k) contribution limits for this year?” or “Is an IRA better than a 401(k)?

In this article, I’ll answer those questions, discuss the rules, tax implications and strategy behind contributing to a 401(k) plan and explain why it’s important to take advantage of a company match.


Table of Contents


What Is a 401(k) Plan?

A 401(k) plan is a tax-advantaged retirement investment account that companies often offer to their workers.

It’s also what’s called a “defined contribution” plan because employees set aside, or “contribute,” a percentage of their paychecks to their 401(k)s.

The name 401(k) comes from the section in the Internal Revenue Service tax code that governs it.

Money expert Clark Howard loves 401(k) plans, especially because employers often offer “free money” via what’s called a company 401(k) match. You can also keep your 401(k) even if you leave the company.


How Does a 401(k) Plan Work?

Typically, a company that offers a 401(k) plan will tell new employees about it during orientation.

Some companies automatically enroll new employees into the plan and give them the choice to opt out. Other employers require workers to self-enroll, usually by filling out paperwork with a Human Resources representative.

If you’re planning to contribute to a workplace 401(k) plan, you have a few decisions to make:

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There are two hugely important things to understand about 401(k) plans:

  1. Many companies offer a “match.” If you put your money into their 401(k) retirement plan, they’ll put company funds into your plan. This is in addition to whatever they’re paying you for your job.
  2. 401(k) plans offer huge tax advantages. The IRS still wants a piece of your money. But it will reward you if you save and invest in your own future.

Whether you contribute to a Roth or traditional 401(k), you’re investing in a tax-advantaged account.

Any money you contribute to a traditional 401(k) is considered “pre-tax.” That means the money comes out of your paycheck before Uncle Sam charges you taxes. So contributions to traditional 401(k) plans lower your taxable income. Plus, your investments will grow tax-free until you withdraw the money in retirement.

Any money you contribute to a Roth 401(k) is “post-tax,” meaning you’ll owe income taxes on the money upfront. And then your funds will grow tax-free until you withdraw in retirement, at which time you won’t owe a cent in taxes.


What Are the 401(k) Contribution Limits for 2021?

Defined Contribution Plan Limits2021
Maximum employee contributions (under age 50)$19,500
Employee catch-up contributions (age 50+)$6,500
Contribution limit, all sources (under age 50)$58,000*
Contribution limit, all sources (age 50+)$64,500*

*Or 100% of your annual compensation if that’s a lower number.

If you’ll be younger than 50 years old on Dec. 31, 2021, you can contribute up to $19,500 to your 401(k) plan this year.

If you’re contributing to a 401(k) plan at multiple jobs, or if you’re splitting your contributions between Roth and traditional 401(k) plans, you’re still limited to $19,500 in total contributions for 2021.

Including your contributions and any money that your company contributes to your 401(k), the IRS allows you to get up to $58,000 in new money put into your 401(k) plan(s) in 2021.

Once you turn 50 years old, the IRS allows you to contribute an additional $6,500 to your 401(k) this year. So you’re allowed to put in $26,000 total. And including your employer’s contributions, you’re allowed to get a total of $64,500 put into your account.

However, in all circumstances, you’re allowed to contribute to a 401(k) plan only if you’re a current employee of that company. Leave your job for any reason, and you won’t be able to keep contributing to that company’s plan.

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There are some more nuances and things to consider as it relates to 401(k) contribution limits for 2021. If you’d like to read about contribution limits in even more detail, you can do so here.


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

If your company offers a 401(k) match, you can rejoice. You have access to arguably the most helpful tool that exists in terms of funding your retirement.

But you may be asking questions such as:

  • Just what is a company match?
  • How does it work?
  • What is the ideal strategy?

Many employers offer to “match” at least a portion of your 401(k) contributions. For example, if you put in a dollar, your company may put in 50 cents — up to a certain percentage of your income.

If you have the opportunity to get a company match on your 401(k), do everything in your power to get the maximum amount. A company 401(k) match is essentially free money. Not only that, but it’s free money that will grow tax-free until you withdraw it during retirement.

“The beauty of an employer match is that it’s the equivalent of an automatic pay raise,” Clark says. “No need to ask your boss, get a good quarterly review or hope your company has a good year so there’s money for a raise!”

The most common company match is 50 cents for every dollar you contribute up to 6% of your pre-tax annual income. Here’s a hypothetical example of that match to make it a little clearer.

401(k) Match Example

ElementAmount
Annual Income$50,000
Your 401(k) Contribution (%)6% of income
Your 401(k) Contribution ($)$3,000
Company Match (%)50% of your contributions
Company Match ($)$1,500
Combined 401(k) Contribution$4,500
Your Taxable Income$47,000

401(k) Match: The Case for Getting the Maximum

If you aren’t currently contributing to your 401(k) or you’re contributing — but not enough to get the biggest possible company match — you’re leaving money on the table.

Clark puts this in a more optimistic, positive framework. He says deciding to contribute up to the maximum company 401(k) match is a great way to, in essence, give yourself a raise.

Some companies give you a 401(k) match, but it disappears if you leave the company prior to a certain date. This is called “vesting.”

Other companies make “non-elective contributions” to the 401(k) of every employee regardless of whether the employee is contributing anything. Sometimes profit-sharing programs also pay into 401(k) plans.

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RELATED: 401(k) Match: What Is It, How It Works


Roth vs. Traditional 401(k): Which Is Better?

Understanding Roth vs. traditional 401(k) plans comes down to taxes. So the rules bear reiterating here.

With a Roth 401(k), you contribute post-tax dollars. This means that you’ll pay income taxes on the money that you put into your 401(k). However, you’ll never pay a cent in taxes again as long as you follow the withdrawal rules.

With a traditional 401(k), you contribute pre-tax dollars. This means that the money you put into your 401(k) will reduce your taxable income for the year. You’ll pay income tax on the money when you withdraw during retirement.

Roth 401(k) plans debuted in 2006, but they’ve gotten much more popular recently. Most companies now offer a Roth 401(k) option. Unlike Roth IRAs, Roth 401(k) contributions aren’t restricted by specific income limitations.

Clark strongly prefers that you contribute to a Roth 401(k) instead of a traditional 401(k) if you’re able to afford the tax bill now. That’s because he expects tax rates to increase in the future to finance federal budget deficits. For most people, he thinks that you’ll come out ahead in the long run by paying taxes now rather than later.

“A Roth 401(k) is vastly superior to a traditional 401(k),” Clark says. “There’s a good chance tax rates will be higher when you go to spend your nest egg [in the future].”

But he adds that, if you earn enough money to pay 32% or more in federal income tax in 2021, you should stick with a traditional 401(k) ahead of a Roth.

Even if you contribute to a Roth 401(k), keep in mind that any company match must be in a traditional 401(k) account. That makes sense, because the IRS doesn’t initially tax company match funds. But they eventually want a chance to get a piece of that money, which wouldn’t be possible if company match funds went straight into a traditional 401(k).

You can contribute to both a traditional and a Roth 401(k) if your company allows you to do so.


Choosing Your 401(k) Investments

A typical 401(k) plan will offer somewhat limited investment options.

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Usually, those options include a mix of mutual funds and exchange-traded funds (ETFs). Often a 401(k) plan will provide options for small-, mid- and large-cap U.S. stocks, a few international options and a few bond options.

Clark’s favorite is a target date fund. Pick the year closest to when you plan to retire and put all your 401(k) funds into it. The target date fund will automatically adjust your portfolio allocation into less risky investments as you get closer to retirement.

Some companies automatically enroll employees into their 401(k) plan. In those instances, they’ll usually put your money into a target date fund.


IRA vs. 401(k): Which Is Better and What’s the Difference?

There are two main types of tax-advantaged retirement accounts: a 401(k), which is attached to a job, and an IRA, which usually is separate from a job.

IRA stands for Individual Retirement Account. With the exceptions of SEP IRA and SIMPLE IRA plans, you won’t be getting a company match within your IRA. It’s on your shoulders.

The contribution limits also are much lower: $6,000 in 2021 if you’re younger than 50 with an additional $1,000 in catch-up contributions allowed if you’re 50 or older.

Plus, with a Roth IRA (as opposed to a traditional IRA), you may be disqualified from contributing at all if you make too much money.

IRAs almost always offer more investment options. And it’s very possible that opening an IRA at a place like Fidelity, Schwab or Vanguard will cost you less money in fees than your company 401(k) plan.

You can contribute to a 401(k) and an IRA simultaneously. However, if your company offers a low-cost 401(k) plan (one with combined annual fees of less than 0.50%), Clark recommends that you contribute to your 401(k) until you reach the IRS limit — then think about contributing to an IRA.

“With a 401(k), the money automatically comes out of your paycheck,” Clark says. “You don’t have to have the best of intentions to put the money in. Automatic is great.”

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Want to explore IRA vs. 401(k) in greater detail? I’ve got you covered with this article. You can also learn more about Clark’s recommended priority list for 401(k), IRA, HSA and taxable investment accounts here.


Withdrawal Tax Rules and 401(k) Required Minimum Distribution (RMD) Rules

Perhaps you’ve inherited a huge sum of money or you’re a child prodigy entrepreneur. You’re set: Congratulations! But for most of us, funding retirement is a long-term process that can begin as soon as we enter the job market and can take decades.

It’s important to understand the end game with any important goal, and retirement is no different.

There are 401(k) withdrawal rules (and penalties for breaking them). The key age to remember when it comes to 401(k) withdrawals is 59½. If you wait at least that long, you’ll be able to take out your money penalty-free.

If you take money out of your 401(k) before you’re 59½ years old, the IRS will charge you a 10% early withdrawal penalty.

No matter what age you are when you take out money from a traditional 401(k), you’ll owe federal income taxes on it. And possibly state income taxes, depending on where you live.

There are several common exceptions that allow you to withdraw without penalty. One of the most prevalent is called the Rule of 55. If you leave your job for any reason after turning 55 years old, it’s possible to withdraw from your 401(k) plan at that company without paying a penalty.

So you’re allowed to take money out of your 401(k) when you’re 59½. But you’re also required to withdraw some money annually starting the year after your 72nd birthday. The IRS wants to tax your money at some point — and, well, nobody lives forever. These are called Required Minimum Distributions, or RMDs.

You don’t have to take any RMDs from the 401(k) at your current company while you’re still working, even past your 72nd birthday.


Final Thoughts

Digesting and understanding every 401(k)-related detail at one time can feel overwhelming.

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Just know that a 401(k) is a great tool you can use to save and invest for retirement. That’s especially true if your company offers you a company match.

Outside of meeting your daily needs (such as shelter, food and water), Clark thinks saving for retirement is the most important priority. So if you’re positioned to take full advantage of a 401(k), it’s a great idea to do so.


More Clark.com 401(k) and IRA Content Organized By Topic:

This article is designed to serve as a primer on what a 401(k) plan is, how it works and why it’s a powerful tool in your retirement arsenal.

However, tax-advantaged retirement accounts such as 401(k) plans and IRAs are nuanced topics. If you’d like to get more in-depth information on a particular area, Clark.com has written the following more detailed articles, which I’ve organized by topic.

401(k) Rules: Contribution Limits, Withdrawals and More

Roth vs. Traditional 401(k) Plans

Understanding 401(k) Rollovers

For Those Interested in IRAs

Options for the Self-Employed and Small Business Owners



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