What Is a 401(k) — And How Does It Work?
For most Americans, a 401(k) is the cornerstone of a retirement savings strategy. But despite its popularity, many workers do not know the ins and outs of how a 401(k) really works. That's where we come in!
Understanding the details of your 401(k) will help you make smarter investments so you can grow your wealth with confidence. Let's break down everything you need to know to take full advantage of this powerful retirement tool.
Key Takeaways
A 401(k) is a retirement savings plan that lets employees save and invest a portion of their income.
Employers often match a percentage of employee 401(k) contributions, increasing your savings right away.
A 401(k) offers various investment options, including mutual funds, stocks, and bonds, allowing employees to tailor their portfolios to their risk tolerance and retirement goals.
The funds in a 401(k) grow tax-deferred, meaning you don’t pay taxes on the money until you withdraw it in retirement. This can result in significant tax savings.
What Is a 401(k)?
A 401(k) is an employer-sponsored retirement savings plan that lets you invest a portion of your salary into various stocks, bonds, and funds. If you make smart investments, your savings will grow over time. Then, when you retire, you can start withdrawing funds from your account.
In the U.S., 401(k) plans are the most common method used to save for retirement. It’s called a “401(k)” because it was first instituted by Section 401(k) of the Internal Revenue Code.
Traditional 401(k) vs. Roth 401(k)
There are two main types of 401(k) plans: traditional and Roth.
Traditional 401(k):
Contributions to a traditional 401(k) are made with pre-tax dollars, meaning the money is deducted from your gross income before taxes are applied. This reduces your taxable income for that year.
The money in a traditional 401(k) grows tax-deferred, meaning you don’t pay taxes on investment gains until you withdraw the funds in retirement.
Once you start making withdrawals, they will be taxed as ordinary income.
Roth 401(k):
Contributions to a Roth 401(k) are made with after-tax dollars, meaning you pay taxes on the money before it goes into your Roth 401(k).
Because your contributions are already taxed, your withdrawals after retirement will be entirely tax-free. This includes both contributions and investment earnings, as long as certain conditions are met (e.g., the account must be held for at least five years, and you can’t start withdrawing funds until after age 59½).
A Roth 401(k) is a great option if you expect to be in a higher tax bracket after retiring, since you pay lower taxes now than you would then.
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How Your 401(k) Plan Works
A 401(k) plan is designed to maximize your retirement savings through long-term investments and tax savings. Here’s how it works.
Employee Contributions
When you participate in a 401(k) plan, you allow a portion of your salary to be deducted and contributed to your retirement account. These contributions can be made either on a pre-tax basis (for a traditional 401(k)) or an after-tax basis (for a Roth 401(k)). Pre-tax contributions lower your taxable income for the current year, while Roth contributions will let you make tax-free withdrawals later on.
401(k) Contribution Limits
The IRS sets limits on how much you can invest in your 401(k) every year. For 2024, the annual limit is $23,000. If you are 50 or older, you can invest an additional $7,500 via catch-up contributions, raising the total limit to $35,000.
Employer Matching Contributions
Many companies offer employer matching for their 401(k) plans. This means they will automatically match a percentage of their employees’ 401(k) contributions. For example, a company might offer a dollar-for-dollar match for contributions of up to 10% of your salary. If you earn a salary of $100,000 and contribute 10% ($10,000), your employer will also add $10,000 to your 401(k) account. This is effectively free money, making a 401(k) plan all the more valuable for workers.
Investment Options
401(k) plans offer a range of investment options, typically including a mix of mutual funds, which can include stocks, bonds, and other assets. The specific options available will depend on your plan, but generally include:
Stock funds: Higher potential returns but greater risk.
Bond bunds: More stability with lower returns.
Target-date funds: Automatically adjust your investment mix as you approach retirement, prioritizing safer investments later on.
PRO TIP: When choosing your 401(k) investment strategy, it’s always wise to diversify your portfolio. This will increase your returns while shielding you from market volatility. Consult a fiduciary financial advisor to learn more about what investments make sense for you!
Taxes
The primary appeal of a 401(k) is its tax advantages.
Contributions to a traditional 401(k) are made with pre-tax dollars, reducing your taxable income for the year. The investments grow tax-deferred, meaning you won’t pay taxes on the earnings until you withdraw them in retirement.
Roth 401(k) contributions, on the other hand, are made with after-tax dollars, but withdrawals in retirement, including earnings, are tax-free.
Withdrawals and Distributions
Withdrawals from a Traditional 401(k)
You can start withdrawing funds from your traditional 401(k) after age 59½. Withdrawals before this age incur a 10% penalty in addition to regular income taxes. There are some exceptions to this, such as when:
You have significant medical expenses
You become disabled
You have a birth or adoption in your family
Once you turn 73, you will have to start taking required minimum distributions (RMDs) from a traditional 401(k).
Withdrawals from a Roth 401(k)
Withdrawals from a Roth 401(k) have different rules compared to a traditional 401(k). You can withdraw your contributions (the money you originally put into the account) at any time, tax and penalty-free, since these contributions were made with after-tax dollars.
However, if you withdraw earnings (the return on your investments) before age 59½ or before the Roth 401(k) has been open for at least five years, those earnings are subject to a 10% penalty and regular income taxes. As with a traditional 401(k), there are some exceptions to this rule.
Starting in 2024, Roth 401(k)s do not mandate any RMDs. You can leave the funds in your Roth 401(k) as long as you choose.
401(k) Loans
Many 401(k) plans allow participants to borrow against the savings in their 401(k) plan. These loans must be repaid with interest, and failure to repay can result in the loan being treated as a taxable distribution.
PRO TIP: While borrowing from your 401(k) can provide short-term relief, it can hinder long-term growth. Explore all other options before tapping into your retirement savings.
Traditional 401(k): Pros and Cons
A traditional 401(k) is a widely used retirement savings plan that offers several advantages, but it also comes with some drawbacks. Understanding both can help you decide if this option aligns with your financial goals.
Pros of a Traditional 401(k)
Immediate Tax Benefits: Contributions to a traditional 401(k) are made with pre-tax dollars, which reduces your taxable income for the year. This can result in significant tax savings, especially if you’re in a higher tax bracket.
Tax-Deferred Growth: The investments in a traditional 401(k) grow tax-deferred, meaning you don’t pay taxes on them until you withdraw the money in retirement. This allows for the potential of compounded growth over time.
Employer Matching: Many employers offer to match a portion of your contributions, effectively increasing your retirement savings without additional out-of-pocket expenses.
High Contribution Limits: The IRS allows for substantial contributions, with limits set at $23,000 for 2024, plus an additional $7,500 in catch-up contributions for those aged 50 and older. This enables you to save a significant amount of money each year.
Cons of a Traditional 401(k)
Taxable Withdrawals: All withdrawals from a traditional 401(k) are taxed as ordinary income. This could be a disadvantage if you expect to be in a higher tax bracket in retirement or if tax rates increase in the future.
Required Minimum Distributions (RMDs): Starting at age 73, you are required to begin taking RMDs from your traditional 401(k), whether you need the money or not. Failing to take RMDs can result in hefty penalties.
Early Withdrawal Penalties: If you withdraw funds before age 59½, you typically face a 10% penalty on top of ordinary income taxes, which can significantly reduce your savings.
Limited Investment Choices: While 401(k) plans generally offer a variety of investment options, they are often limited to the funds chosen by your employer, which might not include the best-performing or lowest-cost options available in the broader market.
Roth 401(k): Pros and Cons
A Roth 401(k) is a relatively new option that combines the benefits of a Roth IRA with the structure of a traditional 401(k). Like any financial product, it has its advantages and disadvantages.
Pros of a Roth 401(k)
Tax-Free Withdrawals: The most significant advantage of a Roth 401(k) is that withdrawals in retirement, including earnings, are completely tax-free, provided you meet the requirements (e.g., the account must be held for at least five years, and withdrawals must begin after age 59½).
No Income Limits: Unlike Roth IRAs, which have income limits that restrict eligibility, anyone can contribute to a Roth 401(k) regardless of their income level.
Tax Diversification: Having a Roth 401(k) can provide valuable tax diversification in retirement, allowing you to manage your withdrawals strategically and potentially reduce your overall tax burden.
No RMDs: Beginning in 2024, Roth 401(k) accounts will no longer be subject to RMDs during the account holder’s lifetime, allowing your money to grow tax-free indefinitely.
Cons of a Roth 401(k)
No Immediate Tax Benefit: Contributions to a Roth 401(k) are made with after-tax dollars, which means there’s no reduction in your taxable income in the year you contribute. This could be a drawback if you’re looking for immediate tax relief.
Contributions Feel More Costly: Since Roth contributions are made after taxes, they can “feel” more expensive upfront compared to pre-tax contributions in a traditional 401(k).
Limited Investment Choices: As with traditional 401(k)s, the investment options in a Roth 401(k) are often limited to those selected by your employer, which might not include the best-performing or lowest-cost options available.
Traditional 401(k) vs. Roth 401(k): Which Is Better?
The decision between a traditional 401(k) vs. a Roth 401(k) will ultimately depend on your unique needs and goals. There’s no one-size-fits-all answer. However, there are some general guidelines that can help you make the right choice.
A traditional 401(k) is ideal if you want immediate tax relief and you expect to be in a lower tax bracket during retirement. However, the future tax burden and mandatory distributions should be carefully considered in your retirement planning.
A Roth 401(k) is better if you expect to be in a higher tax bracket in retirement or want the peace of mind that comes with tax-free withdrawals. However, the lack of immediate tax benefits and the need to plan for after-tax contributions are important considerations.
PRO TIP: Even with these tips, making the right choices with your finances can still be tough. A qualified fiduciary financial advisor can learn the unique details of your situation and offer advice tailored just for you.
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Managing Your 401(k) When Leaving Your Job
When you leave an employer, you generally have four options for handling your 401(k) balance.
Option #1: Leave the Money in Your Former Employer's Plan
In most cases, you can simply leave your 401(k) funds in your previous employer’s retirement plan. The account remains active, and your investments continue to grow under the terms of the original plan. This approach can be convenient if you prefer not to move your funds right away or if the plan offers competitive investment options and fees.
Pros: This option is the simplest; you don’t have to do anything, and your funds can continue to grow tax-deferred. It can also be beneficial if your former employer’s plan offers superior investment options or lower fees compared to your new employer’s plan.
Cons: You might have limited access to the plan, and some employers may charge maintenance fees for accounts held by former employees. Additionally, managing multiple accounts across different employers can be cumbersome.
Option #2: Roll Over the Funds to Your New Employer's 401(k) Plan
This option allows you to transfer your 401(k) balance from your old employer’s plan to your new employer’s plan. It consolidates your retirement savings into one account, making it easier to manage and monitor your investments under your new employer.
Pros: Consolidating your retirement savings into one account can simplify your financial management. Rolling over to a new employer’s plan may also provide access to better investment options or lower fees.
Cons: Not all employer plans accept rollovers, so you’ll need to verify this with your new employer. Additionally, the investment options in your new plan might not be as diverse as those available in an IRA
Option #3: Roll Over the Funds into an IRA
This option involves moving your 401(k) balance into an IRA. IRAs generally offer a wider array of investment choices than most 401(k) plans, giving you more control over your portfolio. This option also allows for continued tax-deferred growth or tax-free growth if you choose a Roth IRA.
Pros: Rolling your 401(k) into an Individual Retirement Account (IRA) often provides the broadest range of investment options, including stocks, bonds, mutual funds, and ETFs. IRAs typically offer more flexibility than 401(k) plans in terms of investment choices and account management. Additionally, IRAs are not subject to RMDs until age 73, similar to traditional 401(k)s, and Roth IRAs never require RMDs during the account holder’s lifetime.
Cons: You may lose certain protections that 401(k) plans offer under the Employee Retirement Income Security Act (ERISA), such as protection from creditors in bankruptcy. Additionally, IRA fees can sometimes be higher depending on the account provider.
PRO TIP: If you opt to rollover your funds, always choose a direct rollover if possible. This will ensure that your funds remain tax-advantaged and avoid the complications associated with an indirect rollover.
Option #4: Cash Out the Account
Cashing out your 401(k) means withdrawing the full balance and receiving a lump sum payment. This option provides immediate access to your funds but comes with significant tax implications and penalties, particularly if you are under the age of 59½. It’s generally recommended only in cases of financial necessity.
Pros: This option provides immediate access to your funds, which might be necessary in cases of financial hardship.
Cons: Cashing out is generally not recommended unless absolutely necessary because it comes with significant drawbacks. The entire balance is subject to ordinary income tax, and if you are under 59½, you’ll also face a 10% early withdrawal penalty. This can significantly reduce the amount you actually receive.
Your 401(k) Can Help Secure Your Financial Future!
An optimized 401(k) is key to protecting your finances and growing your wealth for retirement. By understanding how your 401(k) works, you can make informed decisions to maximize your savings and take full advantage of the many benefits it provides.
Of course, saving for the future is nothing if not complex. At TrueWealth Financial Partners, we’re here to help you every step of the way. Whether you’re just starting your career, transitioning to a new job, or planning for retirement, our team of financial experts is ready to provide personalized advice tailored to your unique needs.
Schedule a free consultation with TrueWealth Financial Partners, and one of our experienced fiduciary financial advisors will be happy to assist you. Let’s work together to create a retirement strategy that ensures your financial security for years to come!
401(k) FAQs
What is the difference between a traditional 401(k) and a Roth 401(k)?
Traditional 401(k): Contributions are made with pre-tax dollars, reducing your taxable income for the year. However, withdrawals in retirement are taxed as ordinary income.
Roth 401(k): Contributions are made with after-tax dollars, meaning there’s no immediate tax benefit, but withdrawals in retirement are tax-free, including any investment earnings, provided certain conditions are met.
How much should I contribute to my 401(k)?
The ideal contribution amount varies depending on your financial situation, but a common recommendation is to contribute at least enough to take full advantage of your employer’s matching contributions. Many financial advisors suggest aiming to save at least 10-15% of your income for retirement, including employer matches.
What happens if I contribute too much to my 401(k)?
If you exceed the IRS contribution limit for your 401(k), you could face penalties, including a 10% fine plus any unpaid income taxes on the excess contributions. To avoid this, most 401(k) plans have safeguards in place, but if you have multiple plans or switch jobs mid-year, it’s important to monitor your contributions closely. If you do overcontribute, you need to request a refund of the excess amount by April 15 of the following year to avoid penalties.
What if I have multiple 401(k) accounts?
If you have multiple 401(k) accounts from different employers, you are still limited to the total annual employee contribution limit ($23,000 in 2024). This means you must carefully allocate your contributions across all accounts to avoid exceeding the limit. Each account, however, can also receive employer contributions up to the combined contribution limit.
When can I start withdrawing money from my 401(k)?
You can begin withdrawing from your 401(k) without penalty at age 59½. Withdrawals before this age are typically subject to a 10% early withdrawal penalty, in addition to regular income taxes, unless you qualify for specific exceptions.
Can I borrow from my 401(k)?
Yes, many 401(k) plans allow participants to take out loans against their savings. These loans must be repaid with interest, and if not repaid, the loan amount may be considered a taxable distribution.
What are the new Roth 401(k) rule changes for 2024?
Starting in 2024, the SECURE 2.0 Act eliminates required minimum distributions (RMDs) for Roth 401(k) accounts, allowing your money to grow tax-free indefinitely. Additionally, employers can now contribute matching funds directly to your Roth 401(k), but these contributions will be taxed as income in the year they are made. This change aligns Roth 401(k)s more closely with Roth IRAs, which do not have RMDs.
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Take the next step in securing your retirement! Contact TrueWealth Financial Partners today and let our experienced fiduciary financial advisors help you maximize your 401(k) and build a solid financial future.
Your path to a confident retirement starts here!
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