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Updated on June 9, 2023
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We all know that saving consistently is essential to achieving financial stability—and one of the most significant long-term savings goals for most people is retirement. Planning for retirement may seem daunting, but having a clear understanding of the available options can make it much easier.
One of the most popular retirement savings vehicles are 401(k) plans, which are employer-sponsored retirement savings accounts. Your 401(k) comes with certain tax benefits and a variety of investment options, and may also include an employer matching program—which can help you grow your nest egg more quickly than you would by only contributing ordinary income.
In this article, we’ll discuss what a 401(k) is, how it works, its benefits, and other essential aspects you need to know about this retirement plan.
A 401(k) is a retirement savings plan offered by employers. The name “401(k)” comes from the IRS tax code subsection that governs these plans.
By contributing to a 401(k), employees can take advantage of various tax benefits and grow their retirement savings over time. For example, in a traditional 401(k) plan—the most common type—contributions are made pre-tax, which means putting money in the account lowers your taxable income the year you make the contribution. (It’s also possible to contribute after-tax funds, which allows your retirement nest egg to grow tax-free if your employer offers a Roth 401(k) option.)
The way these plans work is that employees can set aside a percentage of their income to be contributed directly to the account. The funds are then invested in a variety of investment options, such as mutual funds or ETFs. Employer contributions, also known as “matching,” can further boost an employee’s retirement savings plan: if your employer offers a match, they’ll, well, match your contributions to the account up to a certain percentage (for instance, 3% of your salary).
And if you work for yourself or a small business that doesn’t offer a retirement plan, don’t worry—you still have options. Individual Retirement Accounts, or IRAs, are available to anyone who earns a taxable income, which makes them a great resource for self-employed folks or those who regularly switch jobs.
Some of the key benefits of a 401(k) plan include:
You can only access a 401(k) through an employer (though, again, you almost always have access to an Individual Retirement Account, or IRA, regardless of your employment status).
But fortunately, many employers do provide employees with retirement options. After all, they do want to recruit and keep talented applicants. Additionally, employers often offer to match a portion of the money an individual contributes up to a given percent, which—again—is essentially like a free, deferred raise. Because of the power of compound interest, the large annual contribution limit of a 401(k), and the difficulty of setting aside money for retirement, it’s almost always a good idea to take advantage of the employer match if it’s available.
To enroll in a 401(k), employees should review their employer’s plan and contribution options, and set their desired contribution amount. Your HR representative can help you figure out exactly how to do this, but you can usually manage your entire account online. Some employers may also offer other retirement options, such as an annuity, which can help ensure a guaranteed income stream during your golden years.
There are two main types of 401(k) plans: traditional and Roth.
Traditional 401(k) contributions are made with pre-tax dollars, providing an immediate tax break. (In other words, whatever you contribute will not be counted toward your taxable income.) You will, of course, be responsible for paying taxes on those funds when you withdraw them at retirement—which is what makes this type of retirement account advantageous for those who expect to be in a lower tax bracket at that time.
As is true of all Roth accounts—including other types of defined contribution plans as well as Roth IRAs—Roth 401(k) contributions are made with after-tax dollars, allowing for tax-free withdrawals during retirement. This option may be more suitable for those who expect to be in a higher tax bracket when they retire.
No matter which of the two you choose—and many people actually contribute to both kinds of plans!—your money stands to grow thanks to the assets it’s invested in, like stocks and bonds. With most 401(k)s, you’ll have the opportunity to choose from a limited number of options such as mutual funds or target-date funds to help you meet your retirement needs.
Those who are age 50 or older may also be able to stack the odds in their favor by making catch-up contributions. You can also save retirement funds in an IRA if you work for yourself or get laid off.
Required Minimum Distributions (RMDs) are the minimum amounts that must be withdrawn from an employer-sponsored retirement plan by the savings account owners once they reach the age of retirement. In 2023, the age requirement for taking RMDs changed to 73 years of age—which means account owners who have retired must start taking RMDs from their 401(k) plans starting at age 73.
RMDs ensure that plan participants eventually pay income taxes on their retirement savings. The IRS calculates RMDs based on the account owner’s age and the balance of their retirement accounts.
Because taxes have already been paid on Roth contributions, starting in 2024, RMDs won’t apply to Roth 401(k)s any longer. If you have more questions about how these different retirement options work, it’s worth seeking investment advice from a qualified professional.
A 401(k) is designed to be a long-term retirement savings account—which is why the Internal Revenue Service structures the rules to incentivize savers to contribute (by offering a tax deduction) and leave their money where it is. In most cases, savers must wait until age 59 and a half before taking qualified distributions; withdrawing funds before that time can result in significant penalties.
For one thing, early withdrawals are considered taxable income, which means you’ll likely be subject to income tax on the total cash distribution. In addition, there’s a 10% early withdrawal penalty based on the gross amount of the withdrawal.
However, in cases of severe financial hardship, individuals may be eligible for a hardship withdrawal. In order to qualify for this type of withdrawal, savers need to be able to demonstrate immediate and heavy financial need. If they qualify, they access funds from their 401(k) without incurring the 10% penalty, although the withdrawal is still subject to income tax.
Vesting is the process by which employees gain ownership of employer contributions to their 401(k) plan over time. Although your new employer may offer a match from your first day of work, they may not offer ownership of that money until you’ve reached a certain threshold of time at the company. (Of course, employee contributions—the funds you add to the account out of your paycheck—will always be your own.)
A vesting schedule, then, is a calendar laying out the percentage of the employer contributions that an employee owns as they continue in employment with the plan sponsor. Some employers use vesting schedules to incentivize long-term employment, offering partial ownership of employer contributions over a set period.
If your company offers a match on their employer-sponsored retirement plan, taking them up on the offer can be one of the better investment choices you can make. As much flexibility as you might have when working privately with a brokerage, you can’t magically double your own money—although rolling over your 401(k) into an IRA is still a good option if you lose or leave your job.
To learn more about your vesting schedule, you can talk to your plan administrator. And as always, talk to a financial advisor if you want help with your investment strategy.
A 401(k) is an employer-sponsored retirement savings plan that offers tax benefits—along with added extras like employer matching and higher contribution limits than other types of retirement plans. Contributing consistently to a 401(k) and taking advantage of your employer match can significantly grow your retirement savings over time.
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