What is a 401k and How Does it Work?

Even if you’re young, it’s never too early to think about saving for retirement. If you have a job that offers a 401(k) savings plan, enrolling and contributing money will put you on your way to building a nice nest egg.

Whether you’re just starting out or you’re already maxing out your 401(k) contributions — more on that in a minute — it’s helpful to understand how the plans work, what the rules are and your alternatives if your employer doesn’t offer a 401(k).

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

A 401(k) is an employer-sponsored investment plan designed to give you a tax break on your retirement investing.

The idea is that you, the employee, allot a certain amount of your paycheck to go straight into your 401(k). You can do this pre- or post-tax.

It’s up to you how much you want to put in, though the contribution limit as of 2019 is $19,000 of your own money per year.

Once you turn 50 years old, you can make catch-up contributions of an additional $6,000 a year . Those catch-up contributions allow you to build your 401(k) even more as you get closer to retirement.

The best feature of a 401(k): Many employers will match your contributions up to a certain percentage.

What Does 401(k) Stand For?

The name 401(k) has no hidden meaning. It’s a section of the tax code introduced in 1978 designed to make it easier for employers to help their workers get in good financial shape for their retirement years.

The man behind the 401(k), Ted Benna, told Workforce he had no clue that it would become the main way people save for retirement some 40 years later. Yet, here we are.

Benefits of a 401(k)

As with any retirement investment plan, a 401(k) has rules. While a 401(k) carries risks just like all investing, it’s an unequivocally smart move to contribute to one. It’s like paying yourself in retirement.

Here are some of the best perks.

Free Money

Do you like free money? Then a 401(k) is fantastic.

Say your employer offers to match 100% of your 401(k) contributions up to 6% of your income. If you make $40K per year and max out the employer match, you’d put in $2,400 and your employer will kick in another $2,400.

Think of your employer’s match as a part of your compensation package.

It’s Easy

A 401(k) is an easy way to save for retirement without realizing you’re doing it. The money automatically comes out of each paycheck, so you never miss it.

Since your employer is your 401(k) plan sponsor, the fees are usually less than if you set up a retirement account on your own. As with group rates on health insurance, your company can negotiate fees for things like mutual fund managers or financial advisers.

Be Aware of the Limitations

You also need to be aware of what you can’t do with a 401(k), and the rules governing contributions and withdrawals.

Limited Investment Options

A 401(k) typically has more limited investment options than other retirement accounts. This is not necessarily a drawback if you’re unfamiliar with investing and are happy to have an expert do it for you.

A 401(k) isn’t a vehicle for “playing the stock market,” but rather for building wealth, based on your risk tolerance, over the long-term.

Early Withdrawal Penalties

Because a 401(k) is meant to provide you income in retirement, there are penalties for withdrawing the funds early. Most regular savings accounts allow you to withdraw money when you need it. But if you take money from your 401(k) before age 59 1/2, save a few exceptions such as becoming disabled, you’ll pay a 10% penalty and owe income taxes on what you take out.

There are many reasons you might need to take money from your 401(k), and some could qualify as hardships. You may be able to take a hardship withdrawal for things like medical expenses or avoiding foreclosure, but it will be limited to the money you have put in. You can’t withdraw the earnings, and you’ll still be subject to that 10% penalty.

There are also certain circumstances for which you can borrow from your 401(k). But just like any other loan, it must be repaid, on time and with interest.

Vesting

You might come across the term “vesting” when signing up for your 401(k). This refers to how long you need to work for your company before you own all the funds in the account.

Say your company’s vesting schedule is two years. If you quit before that, you would forfeit the employer-contributed funds in the account (though any contributions you made would remain yours). That’s an incentive to stick around for at least two years until you’re fully vested.

How Do 401(k) Taxes Work?

Taxes for your 401(k) work in one of two ways. In a traditional 401(k), you make pretax contributions. With this type of account, you’ll pay taxes when you withdraw the funds after retirement.

Another option is a Roth 401(k), which approaches taxes slightly differently.

How Do 401(k) Taxes Work?

Taxes on your 401(k) work in one of two ways. In a traditional 401(k), you make pretax contributions. With this type of account, you’ll pay taxes when you withdraw the funds in retirement.

Another option is a Roth 401(k), which taxes the contributions you make. That means you withdraw the money tax-free upon retirement.

Traditional or Roth?

Before deciding between a traditional and a Roth 401(k), consider your current tax bracket and the one you expect to be in during retirement.

Most people will be in a lower tax bracket when they retire because their retirement income will be less than their salary while working. In this case, you might choose to stick with a traditional 401(k).

You might have the option to invest part of your money in a traditional 401(k) and part in a Roth 401(k). Check with your employer to see if this is possible.

Ultimately, the decision is yours, though it’s a good idea to speak with a financial adviser to determine what’s right for you.

What Happens to Your 401(k) When You Quit?

Since a 401(k) is an employer-based retirement plan, you’re probably wondering what happens to the money if you quit your job.

While your employer sponsors your account, it doesn’t own it. You own the account, and it’s stored by a brokerage firm. If you quit or are fired, your money stays in the account. It will continue to grow and earn interest, but you can’t make more contributions to it — unless you merge it into a new 401(k) plan with a new employer.

This is called a “rollover.” Rolling over your old 401(k) into a new one is a seamless way to continue saving for retirement.

“For many people, having everything automated through their employer’s 401(k) plan is the only reason they have the discipline to save every month,” said Paul Ruedi Jr., a certified financial planner in Plano, Texas, who specializes in retirement planning.

You could also choose to open an individual retirement account, or IRA, and make contributions on your own. But remember, if your new employer offers a 401(k) with a matching percentage, you should strongly consider enrolling and contributing at least up to the match.

401(k) Investment Categories

A 401(k) helps build your retirement savings by investing your money. You can choose to have complete control over where your money is invested or pick general categories and leave the decisions up to your broker.

Most 401(k) plans have four main investment categories.

Stocks

Your company’s 401(k) may allow you to invest in stocks. If this option is available, you’ll likely be able to purchase only company stock. Individual stocks may be an option if your plan has a broker.

Stock Mutual Funds

A stock mutual fund, which is a more common option, allows you to invest in a pre-set pool of  stocks rather than individual stocks for a more diverse portfolio with less risk.

Bond Mutual Funds

Similar to a stock mutual fund, a bond mutual fund allows investment in hundreds of bonds, which is less risky than investing in individual bonds.

Variable Annuities

Unlike stocks and bonds, annuities give out regular payments once you make an initial upfront investment.

The younger you are, the more risk you can afford to take with your investments. But if you’re nearing retirement age, riskier investments could result in you losing the money you need to live on.

The mix of investments you choose for your 401(k) is up to you, but you should take a few things into account, including your age. Stocks are riskier than bonds, so your 401(k) will likely be heavier with stock investments when you’re younger and switch over to higher bond investment as you get closer to retirement.

What if I Can’t Get a 401(k)?

While a 401(k) is a great benefit, not everyone is eligible. If your company doesn’t offer one, or if you’re an independent contractor, you can still save for retirement. The most common way is via an IRA.

Like 401(k) plans, you can choose a traditional IRA or a Roth IRA. An IRA limits how much you can save per year. As of 2019, the maximum contribution amount is $6,000. For 2020, the limit is $6,500. People 50 or older can contribute an additional $1,000.

Even if you have an employer-sponsored 401(k), you should still consider opening an IRA to supplement your retirement. To diversify the income you’ll have in retirement, consider contributing to your 401(k) at least up to the employer match, and then open a Roth IRA and put as much as you can in that. Then, when you’re withdrawing funds in retirement, you’ll owe taxes only on the distributions from your traditional 401(k). Remember, with a Roth, withdrawals are tax free.

Is a 401(k) a Good Idea?

That’s easy: Yes.

A 401(k) is an ideal first step to saving for retirement. If your employer offers one, look into maxing out the amount it will match, and consider contributing more money each month or opening an IRA too.

Your retired self will be endlessly grateful.

Catherine Hiles is a mother of two trying to balance retirement investment with child care costs and regular savings. She currently has a traditional 401(k), a Roth IRA and a sizable monthly day care payment.

Susan Jacobson, a former editor for Codetic, contributed to this report.