What Is a 401(k) Retirement Plan?
A 401(k) plan is an employer-sponsored retirement account that gets its name from the subsection of the U.S. tax code that establishes it. Employees make contributions from their paychecks directly into their 401(k) plan. Their employers are also able to match their contributions.
What Is a 401(k)?
A 401(k) plan is a retirement plan set up by your employer that allows you to take advantage of tax breaks as you save for your retirement.
You elect to have a certain amount of your income taken out of each paycheck. The income taxes on this contribution are deferred until you withdraw from your 401(k).
Your employer can choose to match your contributions, increasing the amount of money put into your retirement plan. Your employer also gets to deduct its matching contributions.
There are several types of 401(k) plans available that employers may set up and different rules apply to each.
- Traditional 401(k) Plans
- These 401(k) plans allow you to make pre-tax contributions through payroll deductions and your employer may match your contributions. You have a choice of options in which you can invest these contributions. You only pay taxes on the money in your plan when you withdraw from it.
- Roth IRA Plans
- These employer-sponsored plans are similar to traditional 401(k) plans, but your contributions are taxed before you put them into your plan. Income you then earn on your account — including interest, dividends or capital gains — are tax-free when you withdraw money from your Roth 401(k) plan.
- Safe Harbor 401(k) Plans
- While similar to traditional 401(k) plans, these plans require that annual employer contributions are fully vested as soon as they’re made. That means you immediately own the money your employer contributes.
- SIMPLE 401(k) Plans
- These plans allow small businesses to offer cost-effective retirement plans to their employees. Like safe harbor 401(k) plans, contributions your employer makes to your SIMPLE 401(k) is immediately vested. These are available to employers with 100 or fewer employees who earned $5,000 or more in the previous calendar year.
401(k) Contribution Limits
You are limited in how much money you can place into your 401(k) plan each year. The limit may also change from year to year.
If you are 50 or older, you may be able to make an additional contribution that exceeds the standard limit. These are called “catch-up contributions.” They have their own limits that may change from year to year.
|Contribution Type||2020 Contribution Limit|
|Employee contribution (traditional and Roth 401(k) plans)||$19,500|
|Catch-up contribution (employees 50 or older)||$6,500|
|SIMPLE 401(k) employee contributions||$13,500|
|Combined employee and employer contribution||$57,000 ($63,500 for catch-up contributions)|
401(k) Investment Options
A 401(k) plan is usually managed by a financial services group that offers a choice of several investment options.
These are usually mutual funds — portfolios of stocks, bonds or other types of investments. Generally, you pool your contributions with other investors and a professional makes the purchases for everyone contributing.
- Bond Funds
- These funds invest exclusively in bonds or other debt-related securities. They usually pay dividends — typically higher than those on certificates of deposit or money market funds — on a fixed schedule.
- Foreign Funds
- Also called international funds, these are investments in companies outside the United States.
- Index Funds
- Index funds are a type of mutual fund that matches or tracks the performance of a financial market index, such as the Dow Jones 30 industrials or the Standard & Poor’s 500 index. These offer a return spread across the index’s overall performance.
- Large-Cap Funds
- These are mutual funds that invest most of your contributions in companies with large amounts of market capitalization — calculated by multiplying the total number of shares in the company by the current price of each share.
- Small-cap funds
- These are mutual funds that invest in companies with market capitalization typically between $300 million and $2 billion. Small-cap funds offer the possibility of greater investment growth through the companies’ growth.
- Real Estate Funds
- Real estate funds provide investment growth through appreciation. These are mutual funds that invest in different types of securities offered by publicly traded real estate companies.
Traditional vs. Roth 401(k) Retirement Plans
The main difference between these two most common 401(k) plans is how they deliver tax breaks on your retirement savings.
Traditional 401(k) plans let you make contributions now that are not taxed as part of your income. But you have to pay taxes on the money you withdraw from your account when you retire.
Roth 401(k) retirement plans forgo tax breaks now for tax-free withdrawals when you retire — similar to how a Roth IRA works. Roth 401(k) plans are an option for people who expect to be in a higher tax bracket once they retire.
Not all employers offer the option of a Roth 401(k). They typically work best for people who start contributing to them when they are in a low-income tax bracket, but retire in a higher tax bracket. They tend to be a better option or younger people with more time to invest for retirement.
Traditional 401(k) plans may be a better choice for people who wait until later in life to start investing — when they expect to go from a high tax bracket to a lower bracket when they retire.
What Are the Benefits of a 401(k) Retirement Plan?
In addition to the tax breaks a 401(k) plan provides for retirement planning, employer matching contributions are a major benefit of these retirement plans.
These matching contributions effectively add up to “free money” over and above your income that is invested in your retirement plan.
In addition, the money you contribute to your 401(k) plan is invested. If you do that wisely, your investment could grow substantially so that you can have far more money when you retire than you put into your 401(k) plan over the years.
Penalties for Early Withdrawals and Distributions from 401(k) Plans
If you withdraw money from your 401(k) plan before you turn 59 and a half, you will most likely have to pay 10 percent of what you take out as a penalty as well as paying taxes on the withdrawal.
There are only a few reasons — called triggering events — for which you can make early withdrawals or distributions from your 401(k) plan without being subject to the 10 percent penalty.
- The 401(k) plan is terminated
- You become disabled
- A hardship defined by the plan as a triggering event
- You made excessive contributions and money is returned to you to correct the error
- You reach the age of 59 and a half
- Retirement or otherwise leave your job
In 2020, the CARES Act allowed you to withdraw up to $100,000 if you experienced a hardship due to the COVID-19 pandemic without having to pay the 10 percent penalty.
You are still responsible for taxes on the withdrawal, but the taxes would be spread out over three years. Your employer still has to make the determination as to whether you can take the hardship withdrawal.
8 Cited Research Articles
- U.S. Internal Revenue Service. (2020, March 18). 401(k) Plans. Retrieved from https://www.irs.gov/retirement-plans/401k-plans
- U.S. Internal Revenue Service. (2020, January 10). Retirement Topics - 401(k) and Profit-Sharing Plan Contribution Limits. Retrieved from https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits
- American Benefits Council. (2019, January). 401(k) Fast Facts. Retrieved from https://www.americanbenefitscouncil.org/pub/e613e1b6-f57b-1368-c1fb-966598903769
- U.S. Internal Revenue Service. (2019, December 4). 401(k) Plan Overview. Retrieved from https://www.irs.gov/retirement-plans/plan-sponsor/401k-plan-overview
- U.S. Social Security Administration. (2002). Perspectives, What Determines 401(k) Participation and Contributions? Retrieved from https://www.ssa.gov/policy/docs/ssb/v64n3/v64n3p64.html
- U.S. Securities and Exchange Commission. (n.d.). Traditional and Roth 401(k) Plans. Retrieved from https://www.investor.gov/additional-resources/retirement-toolkit/employer-sponsored-plans/traditional-and-roth-401k-plans
- U.S. Securities and Exchange Commission. (n.d.). 401(k) Plan. Retrieved from https://www.investor.gov/introduction-investing/investing-basics/glossary/401k-plan
- Wall Street Journal. (n.d.). What Is a 401(k)? Retrieved from https://guides.wsj.com/personal-finance/retirement/what-is-a-401k/