What is a 401(k) plan?
A 401(k) plan is a retirement benefit offered by many companies to their employees. When an employee joins a 401(k) plan, part of each paycheck is put into their 401(k) account. The employer may match part of the employee’s contributions.
The plan typically offers a number of different investments such as stock and bond mutual funds for the employee to choose where to place their savings. The savings earn interest, capital gains, and dividends and grow tax-deferred, until the funds are taken out. At that time, both the contributions and earnings are taxable.
401(k) plans have largely replaced traditional pensions in the American corporate world. At one time, pensions were the standard part of most employees’ retirement package: work for the same company for 30 or 40 years, and retire with a guaranteed monthly stipend.
Starting in the 1980s, 401(k)s appeared on the scene, originally as a supplement to pensions for high-level executives. But many companies soon began offering 401(k)s to the majority of employees and phasing out pensions.
For employers, 401(k)s promised cost savings compared to traditional pensions. For employees, 401(k)s offered individual choice since the employee was free to choose their own investments from an array of choices. Today, only a small percentage of companies still offer traditional pensions.
How do 401(k)s work?
Employers of all sizes, from sole proprietorships to nonprofits to multinational corporations can offer 401(k)s to their workers. The maximum an employee can contribute to their 401(k) is limited by law; in 2015 the ceiling is $18,000 (plus an additional $6,000 for workers age 50 and over). This is much higher than the $5,500 limit on IRA contributions. The limit is increased regularly to reflect inflation.
The employer can choose to match a portion of the employee’s contributions. In 2015, the total combined contribution by the employee and employer cannot exceed the lesser of $53,000 or 100% of the employee’s salary.
The employee’s contributions to their 401(k) are made with pre-tax dollars (i.e. the amount of contributions is subtracted from taxable income). The employer’s contribution to 401(k)s is also tax-deductible for the employer.
As mentioned, the 401(k) plan offers a range of investments for the employee to choose from, based on their timeline, risk tolerance, and individual preference. The investment grows tax-deferred until the funds are removed.
Many 401(k) plans have a vesting requirement, where you must work for the company for a certain number of years in order to be entitled to the employer’s contributions if you leave.If you leave the company before you are vested, you can only take the funds you have contributed plus any earnings on those funds.
Some plans have a partial vesting process: if you have not worked long enough to be fully vested, you can still take some of the employer’s contributions and their earnings.
How can I access my 401(k) funds?
Generally, you must begin taking funds out of your 401(k) no later than starting April 1 of the year you reach age 70 ½, unless you are still working. The distributions are taxed as ordinary income. If you take funds out before age 59 ½ you will normally be subject to a 10% federal tax penalty, except in cases of disability or death.
There are a few ways you can access the funds in your 401(k) early.
Loans. Participating employees may take out loans from their 401(k) accounts. Loans must be repaid within five years from the date of the loan unless the loan is used to acquire a primary residence.
Hardship Withdrawals. Hardship withdrawals from a 401(k) are allowed in special circumstances and only if all other sources of income have been exhausted and all loans have been taken. In these circumstances 401(k) funds can be used to
Change of Employment. If you participate in your employer’s 401(k) plan and you leave the organization at age 55 or over, you can take a distribution from the account without penalty even if you are not yet age 591/2. The distribution is taxable, but not subject to the 10% penalty. The key is that you must leave the organization in or after the year you turn age 55 (age 50 for police, firefighters, and medics). This provision is in a little-known section of the tax code and applies only to employer-sponsored retirement accounts, not to IRAs.
Roth 401(k)s are a newer offering for many employees. Like a Roth IRA, your contributions to a Roth 401(k) are made with after tax funds, but distributions from the account are not taxable as long as the account is at least five years old and made after the account holder reaches age 59 1/2 or for death or disability.
Roth 401(k)s can be beneficial if you expect your tax rates to be higher in retirement, or if you’re young and have decades of tax-free growth compounding ahead of you, or if you plan to leave your Roth 401(k) to a spouse or heirs who can continue the tax-free growth.
A third type of 401(k) offered by some employers allows workers to make contributions with after-tax dollars. Withdrawals are still taxable, like a traditional 401(k), but with this type of account you can make withdrawals at any time and for any reason without penalty.
Additionally, the contribution limit is much higher with this type of account. Actually, there’s no specific contribution limit for this type of account. As mentioned previously, the total annual contribution to all 401(k)s, including employer matching, is $53,000. So to figure out how much you could contribute to an after-tax 401(k), simply subtract your contributions and your employer contributions to pre-tax and Roth 401(k)s from $53,000. For example, if you contribute $18,000 to a traditional 401(k) and your employer contributes $6,000, then the most you could contribute to an after-tax 401(k) that year would be $29,000 ($53,000 – $18,000 – $6,000 = $29,000).
After-tax 401(k)s are not nearly as common as traditional and Roth 401(k)s. But they are useful for another reason: under some conditions, you can convert an after-tax 401(k) to a Roth IRA.
401(k)s can be a convenient and effective way to save for retirement. Most employees still don’t take full advantage of their 401(k)s, however. Surveys show the average worker contribution to their 401(k) plans is only around 8% of income.
For additional information
This video gives a brief overview of 401(k) plans.
If you have questions about your employer’s 401(k) plans you should consult your employer’s plan advisor or human resources department.
For general information about 401(k) plans, visit the 401k Help Center.
To see how your 401(k) plan stacks up against those of others, see this page.