What is a 401(k) and How Does it Work?

Since their introduction in 1978, 401(k) plans have become the primary retirement savings vehicle offered by employers to eligible employees.

As of September 30, 2022, more than $6.3 trillion in assets are held by more than 625,000 401(k) plans on behalf of nearly 60 million active participants and millions of retirees. 

What is a 401(k)?

A 401(k) is a retirement savings plan designed by Congress to encourage American workers to save for retirement. Offered by many employers, it allows employees to contribute a portion of their income into a tax-favored investment account, which can grow over time and ultimately be used to fund retirement expenses. 

There are two types of 401(k) plans, each with distinct tax benefits.

Traditional 401(k)

Overview

The traditional 401(k) is a defined contribution retirement plan in which employee contributions are deducted from gross wages before taxes are deducted.

That means your taxable income is reduced by the amount of contributions made throughout the year, lowering your tax liability. Also, investment earnings inside a 401(k) are not currently taxed, allowing them to accumulate more quickly. 

No taxes are owed until you begin to take withdrawals from your plan, which are taxed as ordinary income. Any withdrawals taken before age 59 ½ are subject to a 10% penalty on top of taxes owed. 

How Traditional 401(k) Plans Work:

Contributions: Employees can choose to contribute a portion of their pre-tax income up to a maximum annual contribution limit set by the IRA.

401k contribution limits are established each year for the forthcoming year enabling savers to make the necessary adjustments in their spending and withholding to maximize their contributions. The baseline rule for 401k contribution limits is as follows:

The maximum allowable 401k contribution in any year is the lesser of: 

1. A percentage of salaried compensation established by the employer, or
2. The fixed dollar limit set by the IRS each year (currently $16,500)

For 2023, the contribution limit is $22,500 for individuals under 50 and $30,000 for those 50 or older. 

Employer matching: Most employers offer some form of a matching contribution, which is like free money and a guaranteed return on your investment. A typical employer match might consist of a 50% contribution of up to 6% of your salary. If you earn $70,000 and contribute at least 6% ($4,200), the match will increase your contribution by $2,100. Forgoing that match by not contributing enough is like losing $2,100 a year. 

Some employers may also offer a vesting schedule, meaning that employer contributions become fully owned by the employee after a certain period (i.e., three years). 

Investment options: Employees can choose from a menu of investment options offered by the plan, including a variety of mutual funds, exchange-traded funds, and money market funds. 

Most plans offer a dozen or more options, allowing plan participants to create an asset allocation strategy that meets their investment and risk profile. You can change your allocation as your investment objectives or risk tolerance change (i.e., allocate more heavily to fixed-income options as you approach retirement). 

Withdrawals: You can start taking withdrawals at age 59 ½. Withdrawals taken prior to age 59 ½ will be assessed a 10% penalty on top of taxes owed. However, there are exceptions to that rule.

Separation from service: If you leave your employer after age 55 for any reason, you may start taking withdrawals without penalty. 

Substantially equal periodic payments (SEPP): You can take early withdrawals if you take them as equal installments for a specific period of time or until you reach age 59 ½, whichever is longer. Another option is to take equal installments over your lifetime.

Each method has specific calculations and requirements that, if not met, could result in a retroactive 10% penalty, so it is advisable to seek the guidance of a tax professional.

Qualified domestic relations order: If you tap into your 401k to satisfy a divorce decree, you can do so without incurring a penalty.

Medical expenses: If you incur medical expenses, you can use your 401k funds to the extent that your expenses exceed 7.5% of your adjusted gross income. 

Disability: If you are disabled for an extended period of time as a result of an accident or an illness and cannot perform the duties required of your employment or any similar type of work, you can withdraw 401k funds without penalty. You will need to prove that you are disabled.

Military reservists: If you are a member of the military reserve, you may be able to take early withdrawals if you are called to active duty for a minimum of six months.

Loans: If you need to access your 401(k) funds, it may be less expensive to borrow the funds, especially if it is to cover short-term needs. While borrowing from your 401(k) plan can be less expensive than an early withdrawal, there are requirements and limitations attached.

For instance, you are required to repay the loan within five years. Plus, you must remain with your employer throughout the duration of the loan.  

The interest rate on 401(k) loans is typically relatively low, and the interest you pay is paid to your account. Not all plans allow for loans, but if they do, it may be better than taking a taxable withdrawal and losing a part of your gains to penalties.

Required Minimum Distributions (RMDs): The tax code sets a limit on your tax deferral by requiring that you begin taking taxable withdrawals from your 401(k) starting at age 73.

The amount you need to withdraw is based on a calculation of your account balance at the end of the prior year divided by a life-expectancy factor in the IRS’s Uniform Lifetime Table. 

For example, if, at the end of last year, you had $800,000 in your 401(k) and you are currently 75 years old, your expected distribution period would be 22.9 years.

Dividing your account balance by your life expectancy factor would result in an RMD of $34,934, which can be withdrawn weekly, monthly, or even in a lump sum. 

Roth 401(k)

Overview

Roth IRAs are becoming an increasingly popular alternative to traditional IRAs because they offer more flexibility in how and when plan participants can access their money.

For that same reason, Roth 401(k) plans are growing in popularity among employers offering qualified retirement plans. Both allow for tax-free distributions when certain requirements are met, such as abiding by the “five-year rule” for holding the account before taking withdrawals. 

As with the Roth IRA, the Roth 401k allows retirement plan participants to make contributions on an after-tax basis, which then allows them to withdraw their Roth assets on a tax-free basis at retirement (age 59 ½ or later).

The Roth 401k offers additional flexibility for withdrawals, allowing participants to take them if their Roth account has been established for at least five years.

Although Roth 401k contributions are made with after-tax dollars, the ability to accumulate account earnings tax-free and then withdraw them tax-free is gaining broader appeal as more people become concerned with maximizing their retirement income.

Related: The Definitive Guide to Retirement Planning

How a Roth 401k Works

Generally, Roth 401(k) plans are governed by the same rules as traditional 401(k) plans, including contribution limits, employer matching, investment options, vesting, and required minimum distributions. 

The primary difference is the tax treatment of withdrawals. Because contributions are made with after-tax dollars, withdrawals are generally tax-free if certain requirements are met.  

Contributions may be withdrawn at any time. While the Roth IRA allows you to withdraw just your contributions without touching your gains, the Roth 401(k) assumes a portion of your withdrawal is gains relative to the proportionate percentage of gains to contributions in your account.

For instance, if you contributed $10,000 to a Roth 401(k) and have $1,000 in gains, 10 percent of your contribution withdrawal is considered a gain and is taxed accordingly.

The Five-Year Rule: Tax-free withdrawals can be made beginning five years from the first day of the year you make your first contribution. For example, if your first contribution is made in December 2022, the five-year holding period begins on January 1, 2022, and runs through December 31, 2026.

In addition, you must be at least 59 ½ when you make your first withdrawal. But, if you turn 59 ½ and haven’t owned your account for five years, you will have to wait until then to make your first tax-free and penalty-free withdrawal.

Rolling a 401(k) into an IRA

If you leave your employer for any reason, you have several options to consider for your 401(k) plan:

• Keep the money with your former employer’s 401k
• Execute a rollover into an Individual Retirement Account (IRA)
• Roll your money into your new retirement plan if it’s allowed
• Cash out your 401k plan by withdrawing all your money (not recommended)

Your best course of action depends on several factors that should be considered in light of your situation, your attitude about managing your retirement plans, and the specific plan options available to you.

Factors to Consider 

Fees and investment costs: Employer-sponsored plan fees should be compared with the costs associated with investing in an IRA. Large employers can usually negotiate low fees, but they may also charge multiple fees, such as administrative and investment management fees, which can add up.

IRAs established through a mutual fund will incur the sales charges associated with the funds offered. It’s possible to establish a self-directed IRA through an online broker with a minimal annual fee using low-load or no-load mutual funds or low-cost exchange-traded funds. 

Investment options: If your 401(k) plan offers a wide range of investment options enabling you to achieve optimum diversification among several different asset classes, you might be better off where you are.

If the plan’s investment options are limited to just a few types of stock and bond funds, you should consider seeking greater diversification in an IRA.

Plan management: If you decide to leave your 401(k) with a former employer, you will likely end up with multiple retirement plans, whether you open an IRA or enroll in a 401(k) with a new employer or both. An important consideration is whether you have the time or inclination to manage multiple retirement plans. 

If, after comparing cost and investment performance, your new employer’s plan offers an improvement in both (including a broader range of investment choices), your best course may be to transfer to the new plan.

Even if the new plan doesn’t completely measure up to your old plan, consolidating your plans into one is advantageous for easier monitoring and managing of your investments.

How to Roll a 401(k) into an IRA

If transferring to a new retirement plan is not a desirable option or it’s not allowed, you can establish a Rollover IRA. Rollover IRAs—either traditional or Roth—can be established through a bank, a brokerage firm, a custodian, and online trading accounts. 

You can shop and compare fees as well as investment options. The one advantage of a Rollover IRA over an employer-sponsored plan is the range of available investment options. You can usually achieve broader diversification from among a wider choice of asset classes.

A Rollover IRA is also preferable for people who have more than one 401(k) plan from former employers. Managing your retirement assets in one plan is far easier and more effective.

Important Note: When establishing a Rollover IRA, it’s essential to maintain it as a separate account from any other IRA you might have established if you plan on making any future contributions. 

Related: How to Move a Portion of Your 401(k) to Physical Gold & Silver

Why You Don’t Want to Cash Out of Your 401(k) 

Unless you have some urgent need for the funds presently, there is no reason why you should cash out, or withdraw your money from, your 401k plan.

If you take possession of your funds before age 59 ½, you’ll be hit with ordinary income taxes as well as a 10 percent penalty (certain exceptions may apply). 

Even if you plan on rolling the money over to another qualified plan, it’s recommended that you do so with a direct transfer if possible. Although you have 60 days to move the funds into a new plan, it’s not worth the risk of missing the deadline due to some administrative glitch.

Speak with a Financial Advisor

Questions regarding your 401(k), contribution limits, employer match, and other related topics can be overwhelming. It’s a smart idea to find a trusted financial advisor to answer address your questions and concerns.

Consulting with a Certified Financial Planner (CFP) will help ensure that you make informed decisions and maximize your retirement savings.