As society has progressed through the last half of the 20th century and into the 21st century, numerous trends in employment and benefits have undergone significant changes. Pensions have fallen away, giving rise to reduced retirement benefits for many working people. This has made it more important than ever to understand the different retirement plan options that are available. To that end, here we provide a basic introduction to 401(k) retirement plans, the most popular kind of retirement benefit that most US companies offer their employees today.
In this article, we’ll answer common questions like:
- What is a 401(k) plan?
- How does a 401(k) differ from a pension or IRA?
- How does a 401(k) work?
- What are the benefits of a 401(k) plan?
- And much more!
It should be noted at the start, as a kind of disclaimer, that this is merely an informative guide to help you to better understand 401(k) plans and retirement plans. It is not a substitute for professional financial advice from a certified financial planner or other trained professional. Your unique financial situation and needs are best discussed with a financial planner to maximize your savings and retirement security. However, we have worked very hard to make sure that this introduction to 401(k) retirement plans is informative and accurate, based on current regulations and information as of mid-2019.
What is a 401(k) Plan?
In simple terms, a 401(k) plan is a type of retirement plan featuring an investment account, which allows people to contribute pre-tax earnings to the account. The amount you can contribute in a given calendar year is capped (though well in excess of what most average people can contribute, anyway). This has the benefit of reducing your tax burden, as taxable income is decreased while maximizing your investment potential. You can then usually choose a number of different types of investments, based on what your particular plan offers (and your own risk tolerance and goals), or get advice from either a third-party financial planner or one associated with your plan, depending on the specifics of what your employer may offer.
In many cases, one of the most appealing 401(k) benefits comes in the form of employer matching. We’ll discuss this in much greater detail in later sections, but in essence, most employers contribute toward employer 401(k) plans via matching employee contributions, usually on a decreasing scale across the first few percent of salary that an employee contributes. This is in essence “free” money from your employer that you would otherwise not receive.
Before we get into further details about how a 401(k) plan works, we should answer the burning question that many people have – why is it called a 401(k) plan? Does this have something to do with a certain dollar threshold, like 401k, meaning $401,000? Nothing of the sort, it’s actually far more simple and less satisfying than that, though still interesting.
In the 1980s, pensions started to disappear, and the government realized additional plans were needed to encourage retirement savings, as Social Security alone was never intended to provide the entirety of retiree income. So they authorized a type of defined-benefit contribution plan for retirement, and the rules and regulations thereto. It was incorporated into the Internal Revenue Code, part of the US Code, at 26 USC Section 401, subsection (k), hence the moniker 401(k) plan.
Additional retirement plans of a similar nature were developed for other circumstances, such as 403(b) for non-profit organizations, 457(b) plans for government employees, and the somewhat different variant for the government, education, and non-profits, the 401(a) plan. While these other plans are outside the scope of this article, it is worth noting that all are, in essence, retirement plans, with defined benefits and contribution limits, incentives for employees (and in some cases employers) to contribute to the plans, and various regulations on when and how funds can be withdrawn.
How Does a 401(k) Differ from a Pension or IRA?
Other types of major retirement income sources (aside from Social Security) include pensions and IRAs. It’s useful to examine both of these other forms of retirement income, and how they differ from a 401(k) plan.
Pension vs. 401(k)
Pensions were the traditional means by which companies rewarded employees for their years of service, and provided retirement income for those employees. These typically took the form of defined benefit plans as well, wherein every year of service to a company entitled the employee to an additional percentage of their then-current base salary as a retirement benefit, usually only available if you retired from that company after a certain age, and would continue throughout your retirement (or in some cases for a limited number of years after retirement).
These made a great deal of sense for employers and employees back in times where employees tended to work for one, or maybe two companies total throughout their careers. It provided employers with competitive benefits to lure loyal employees to remain with a company for a long time, and employees with an incentive to build a career at a single company. In these days, employees were often seen as more valuable by employers than they are today, and it was a two-way street of shared growth and rewards. As the number of employer’s workers would have in their career began to increase, especially with the various shifts in the workforce and industries between the 1970s and beyond, fewer and fewer people were eligible for pensions of any appreciable amount. This was the main reason why 401(k) plans and other types of retirement plans, which are largely portable and not tied to service at a single employer, were developed.
The way a pension works when you retire is it provides a certain weekly, bi-weekly, or monthly benefit, in the form of a check, usually defined in the form of a total annual benefit based on years of service and various other factors. Pensions are still a part of many existing retiree’s lives, as well as still in use in government, education, and often in places that have collective bargaining trade unions. Outside the US, some countries are still big on pension plans, which may or may not be tied to the employer vs. managed through the government. However, for the vast majority of people in the US today, pensions are no longer a benefit that is offered, nor one that really makes sense, since the average employee today will have 6 major employers throughout their professional career.
IRA vs. 401(k)
Contrary to pensions, IRAs are very much still around and used, though generally not a benefit that an employer offers. IRA stands for individual retirement account, and accordingly, is a type of individual account not tied to an employer, designed to be contributed to as a retirement plan. It is similar to a 401(k) in this way and typically takes a similar form with various investments available depending upon the brokerage who runs the account. The key difference between an IRA and 401(k) mostly stems from employer contributions, which are not part of the IRA scheme but are very much integral to most 401(k) plans. There are other subtler differences as well, but they are largely minor.
As a result, most types of IRAs qualify for employees to transfer in their 401(k) funds if they leave a particular employer. This allows employees to directly manage their accounts after they leave an employer when contributions from them or matching from the employer are no longer a consideration. Alternatively, IRAs can be used directly by anyone to make retirement savings investments, regardless of employment or income situation, up to certain statutory limits, which are generally about 2-3x lower than the limits on a 401(k) plan.
There are other types of IRAs, known as Roth IRAs, which are more specialized and offer opposing tax benefits to that of traditional IRAs or 401(k)s, allowing taxes to be paid up-front on money put into the account, and no taxes to be levied when funds are withdrawn, though this is only available for those hitting certain minimum income thresholds that are above what average workers make in a typical year, and largely outside the scope of this article.
How Does a 401(k) Work?
Returning to 401(k) retirement plans, the next logical question is “how does a 401(k) work?” We’ve outlined the general process below as an overall introduction to 401(k) retirement plans, though the specifics involved will vary from employer to employer. A typical 401(k) example might look like the following:
- After working at a company that offers a 401(k) for a pre-defined period of time, you will become eligible to participate in the 401(k) program. Some companies offer participation immediately upon hire, and others have a waiting period of 3 months, 6 months, or even a year in some cases.
- Once eligible to participate, employees will be able to elect to have a certain percentage of their income set aside, prior to being taxed, and put into a 401(k) account. While there typically are no limits on the percentage that can be contributed, there is a 401(k) annual limit for employee contributions which is $18,500 in 2019 and increases slightly each year to account for inflation. There is also a 401(k) annual limit for combined employee contributions and employer match, which must be the lesser of either the employee’s total annual salary or $55,000.
- Employer matching is often offered and is one of the 401(k) benefits that make it worthwhile. While we’ll discuss this in much greater detail in the next section, in essence, companies often offer their own funds for deposit in employee accounts alongside employee contributions, usually up to a certain threshold. Many companies may offer 100% matching on the first few percent of salary that an employee contributes, and decreasing percentages after that. There are some regulatory 401(k) match limits, but in the case of the vast majority of employees, the main limits are those mentioned in the previous point above.
- The employee contribution funds are removed from each paycheck prior to calculating taxes and other benefits, as well as take-home pay. The employer match is a separate transaction. The deposits into the 401(k) account then are used by the plan manager (usually a major financial company) to buy shares in various funds the plan offers, based on the elections the employee makes. Most 401(k) programs offer several dozen investment funds, and provide information on their financials, goals, and management, allowing employees to choose which funds they wish to invest in, and what percentage of their 401(k) funds should go towards each investment. These elections can often be modified through an online portal or other services by the employee, though are not instantaneous and do take a few days to process in many cases, not taking effect until the next pay period. In many cases, 401(k) planning and advice may be available for free from the company that runs your 401(k), depending on the particular arrangement that your company has worked out.
- In a perfect world, the 401(k) account grows in value over time, from the combination of additional employee contributions, free money from the employer match, and positive changes in market value of the investments. They can also lose money, as all investments are subject to changes in their component stocks, bonds, and funds, which may negatively impact their share price. However, most 401(k) plans offer employees a range of risk options, with much more stable, capital-preserving options like bond funds available that are not likely to increase much in value, but are very unlikely to decrease in value, either, alongside high-risk stock funds that have the potential for great losses but great gains as well.
- In many cases, companies may impose a 401(k) vesting schedule, where their contributions do not become eligible for withdrawal until after a certain vesting period has passed, or are forfeited if you choose to leave the company before a certain vesting period has elapsed. This is growing less and less common with most companies these days, however.
- As you get closer to retirement age, you may wish to contribute more of your funds into your retirement account. These are called 401(k) catch-up contributions. Essentially, they raise the limit on annual contributions – in 2019, the normal 401(k) annual limit is $18,000, but those who are over 50 years of age can contribute an additional $6,000 per year to their 401(k) accounts.
- If you leave your employer, in some cases the 401(k) will still be managed by their organization, meaning you can keep it with their plan manager or move it to another 401(k) or IRA plan managed somewhere else – such as your new employer, or outside any employer system. You will no longer be contributing from your paychecks or receiving employer matches in this case and may want to move it if/when you are eligible to participate in a similar retirement plan at your next employer.
- Funds can then be withdrawn once you have reached a certain age (defined by statute and varies over time based on life expectancy and other actuarial tables), or for a penalty, they can be withdrawn sooner, such as if you have unexpected expenses. In some cases, exemptions from the penalties may be available, as there are certain qualifying life events that allow access to the funds at the normal tax rate only.
- Once 401(k) distribution has begun in retirement, you can set the level (there are usually minimum and maximums) to receive every month. The funds in the 401(k) will continue to gain (or lose) value until such time as they are withdrawn. Ideal circumstances mean you’ll gain in a change of value what you withdraw every month, keeping your funds at a net same level, though in reality most people slowly deplete their 401(k) plans through their retirement years.
There are various other restrictions and rules that apply for employees who make significant sums of money as part of their compensation, though these really only apply to the top few percent of all workers by earnings, and are unlikely to impact most of us ordinary working folks.
What are the Benefits of a 401(k) Plan?
Aside from the obvious benefits of having retirement plan savings to pay your bills and live a good quality of life in your retirement years, 401(k) benefits can be classified into three main categories: 1) tax benefits, 2) free money from employers, and 3) control of investments. We’ll examine each of these in greater detail in this section.
401(k) benefits with regards to income taxes are significant. Because every dollar you contribute toward your 401(k) retirement plan is deducted from your gross income prior to applying calculations for taxes, you can save significantly on your income tax liabilities, for both federal and state income taxes. Say for example you are single, with no kids, and live in California. Your gross annual salary was $60,000, and in the course of the year, you put $10,000 into your 401(k). Assuming no other income offsets, and the standard deduction only, your tax burden in each case will be as follows:
As you can see, not even accounting for changes in the value of the 401(k), you would end up nearly $6,000 ahead in terms of assets that you own (take-home pay plus 401(k) account value) at the end of the year.
Free Money from Employers
As highlighted above, the free money available from your employer as part of a 401(k) match should not be missed out on. A typical rate is usually 100% or 1:1 employer matching of the first 5% of your salary you put towards a 401(k) plan. Some may offer less, like 100% on the first 3%, then 50% on the next 2 or 3%, then nothing beyond that. It varies from employer to employer. For our example, we assumed a 100% match on the first 5% of gross salary contributions. This works out, in our above scenario, to $3,000 in free money going into the employee’s 401(k) each year, which is compounded further by the potential greater increases and reinvestment on the 401(k) account’s value over time.
Control of Investments
Another important aspect of 401(k) benefits is that you retain control of your investments. You get to research, work with your financial planner or account manager, and decide what investments you want your 401(k) funds going into. This runs counter to pension programs or Social Security, for example, which are administered without your control (or even your input, in many cases). This gives people with a 401(k) a level of comfort, feeling in control of their own destiny, and able to play the market, as it were, on their own terms, to try to maximize their investment growth.
How Much Should I Invest in a 401(k) Plan?
How much you should invest in a 401(k) retirement plan is obviously a complex question, with a lot depending on your personal financial situation, and how much you can afford to have taken away from your take-home pay each period. With that said, there are many calculators online which can offer some advice on how much you need to save for retirement, including those from Bankrate, AARP, and many others.
The bottom line here is you should, at a minimum, contribute as much as you can afford, at least as much as necessary to achieve the maximum match benefit from your employer. If you don’t, you’re throwing away free money, and no one wants to do that.
When Can I Get My Money from a 401(k) Plan?
Your 401(k) funds are yours and may be withdrawn at any time. However, if you withdraw them before retirement age, you face a penalty, on top of the ordinary taxes you would have to pay on the withdrawal. Usually, this penalty is 10% federal and 1% state, which is money you are basically throwing away by tapping the funds early. This should be avoided if at all possible.
Once you reach retirement age, you are able to start making withdrawals without any penalty. You must be 59 ½ years in an age prior to tapping your 401(k) to be able to avoid the penalties. In some special cases, those who quit, are fired, or otherwise retire after age 55 may be able to start withdrawing without penalty, but in general, 59 ½ years is the age minimum.
In conclusion, we hope our introduction to 401(k) retirement plans has provided you with some useful information, and encouraged you to start taking advantage of any 401(k) benefit to which you are entitled. It is especially valuable to take advantage of any employer contribution matching, as this is free money that you are otherwise missing out on. Since pensions are no longer part of most people’s lives, it’s more important than ever to understand the difference between an IRA and 401(k), and take advantage of both if at all possible. A robust and healthy plan for retirement will allow you to live as long and as comfortable as possible, with the quality of life you are accustomed to and deserve. Careful planning and savings early on in life can reap big rewards later on.
Some Products for Further Reading
If our guide has got you thirsty for more information on 401(k) plans, IRAs, pensions, or retirement planning in general, there are some great books available from Amazon, including:
This 150-page guide offers basic information and steps that you can take, at any age, to begin your retirement planning efforts.
A short, 60-page guide that can be easily read and understood, covering basic 401(k) investing principles, and providing the extra “push” you might need to start investing in a 401(k) today.
The useful, approachable, and irreverent “for Dummies” series tackles popular 401(k) topics in much greater depth than we could cover here in our article.