How does a 401k work and what is it?

An employer-sponsored retirement account known as a 401(k) plan enables individuals to invest a portion of their income in securities such as stocks and bonds. Approximately 70 million Americans participate in these plans, with a total of nearly $7 trillion in assets, according to a September 2023 report from the Investment Company Institute.

Preparing for retirement is a smart move, and contributing to a 401(k) is an effective way to do so. The automatic withdrawal of funds from your paycheck ensures that you won't spend the money before retirement, and the tax-deferred nature of the plan allows you to invest more now, resulting in more to invest when you retire.

While employers often match their employees' contributions to a 401(k), the IRS imposes restrictions on the maximum amount that can be contributed annually.

CNBC Select provides information on 401(k) plans, including types, withdrawal rules, and more.

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How does a 401(k) work?

An employer-sponsored 401(k) plan is available, where contributions are deducted from an employee's paycheck before taxes and invested in various asset classes, including stocks and bonds.

Although many companies automatically enroll new employees in their 401(k) plans, you may still need to sign up for the program. This policy promotes participation but also requires you to actively opt out if you choose not to contribute.

To determine if your company offers a 401(k) plan, its type, and whether enrollment is automatic, contact your HR department. After your account is created, review your asset allocation to ensure it aligns with your goals.

What is employer matching?

Employers that offer 401(k) plans typically match their employees' contributions up to a specific amount. For instance, you may contribute 10% of your paycheck to a 401(k), but your company may only match the first 6% of that contribution.

Rewritten sentence: You can earn a dollar-to-dollar match for every dollar you contribute, up to a maximum of 3%, after which the match will be 50 cents for every dollar you contribute.

If your employer has a matching plan, the funds you contribute may not be fully vested until a certain period of time has passed. However, your personal contributions are always immediately vested. If you leave the plan or the company before your employer's matching funds vest, you may forfeit a portion of those funds.

In 2022, approximately 16% of employers required workers to wait six years before their matches vested 100%, according to the Plan Sponsor Council of America.

Some companies provide non-matching contributions, which are given regardless of whether you contribute anything.

Types of 401(k) plans

Employer-sponsored 401(k) plans come in various forms.

Traditional 401(k)

A basic 401(k) plan allows employees to contribute a portion of their after-tax wages into a retirement account. Their employer may match their contribution, either fully or partially, or make non-matching contributions. The taxes on contributions and any earnings are taken when withdrawals are made.

Roth 401(k)

Unlike a traditional 401(k), money is taxed before it's put into a Roth 401(k). This means there's less to invest, but you'll be able to withdraw it tax-free. This can be especially beneficial if you expect to be in a higher tax bracket when you retire. Additionally, Roth 401(k) plans are not subject to required minimum distributions.

Safe harbor 401(k)

Safe harbor plans require employer contributions, regardless of employee participation, and are exempt from non-discrimination tests, allowing employees to be fully vested immediately.

Simple 401(k)

A basic 401(k) plan is suitable for companies with up to 100 employees who earn at least $5,000 annually. These plans are similar to safe harbor plans and do not require nondiscrimination testing. Employers are obligated to contribute, even if an employee chooses not to participate.

No other employer-sponsored retirement plans can be offered if workers are enrolled in a SIMPLE 401(k).

Solo 401(k)

If you are self-employed or run a small business with a spouse, you may be eligible for a solo 401(k) plan, which offers the benefits of a retirement account without the need for an outside employer.

How much can I contribute to my 401(k)?

The annual contribution limits for 401(k) plans vary based on the type of plan, with workers over 50 able to make additional contributions, each with its own annual cap.

In 2024, the maximum individual contribution to a traditional 401(k) is $23,000, and the combined employee and employer contribution limit is $69,000. If you're over 50, you can contribute an additional $7,500. However, overcontributing to your plan is possible, though it's rare. Payroll departments and investment firms monitor for it. If you exceed the limit, you must withdraw the excess and pay taxes on it before Tax Day, as per the IRS.

If you don't withdraw it by Tax Day, the overage will still be considered taxable income that year and will be taxed again when you make qualified distributions.

How much should I contribute to my 401k?

It is advised that you contribute at least as much to your 401(k) as your employer is willing to match. If your employer match is 4% of your income, you should aim to contribute at least 4%.

The average 401(k) balance at the end of 2023 was $118,600, according to Fidelity Investments, the largest provider of 401(k) plans in the U.S. However, the amount you should contribute to your retirement account depends on your financial situation, age, and retirement goals.

When can I withdraw from my 401(k)?

Qualified distributions from 401(k) plans can be made penalty-free starting at age 59½, similar to other retirement plans like the 403(b) and Thrift Savings Plan.

Withdrawing from a traditional 401(k) before age 59 1/2 will result in federal and state taxes, as well as a 10% penalty. However, certain hardships may be considered by the IRS, depending on your plan's specific rules. On the other hand, early withdrawals from a Roth 401(k) will only require payment of taxes and penalties on any earnings.

You may borrow money from your 401(k) without penalty, up to 50% of your retirement savings, or a maximum of $50,000.

Required minimum distributions

Starting at age 73, most seniors must begin withdrawing annually from their 401(k) plans, and the amount of their required minimum distribution (RMD) is determined by their age, marital status, and the total value of their retirement accounts.

In 2024, Roth 401(k) accounts will no longer be subject to RMDs.

What happens to my 401(k) if I leave my job?

If you leave a job with a 401(k) account, your employer may have the option to cash out the account or roll it into an IRA if the balance is less than $7,000.

If you're content with your current 401(k) plan's investment options, it may be simple to keep your money in the same account. Alternatively, you can establish a new 401(k) with your new employer.

If your new job offers a 401(k) plan, you can usually transfer your funds from your previous account without penalty, thereby consolidating your funds and increasing your contributions.

Rolling the balance into an IRA can provide more investment options and allow for penalty-free early withdrawals in case of an emergency.

If you choose to cash out your 401(k), you may face a 10% penalty and taxes, and the funds withdrawn will no longer be eligible for investment in a 401(k) plan, potentially increasing your tax bracket.

If you've taken out a 401(k) loan and left your job before you've fully paid it back, you may have to repay quickly. If you default on a 401(k) loan, you'll owe both taxes and the 10% penalty.

401(k) vs. IRA

Both 401(k) plans and Individual Retirement Accounts (IRAs) are widely used for retirement planning in the U.S., as per the Census Bureau. Having both can help diversify your portfolio and safeguard you against market volatility.

Both IRAs and 401(k)s are typically tax-deferred, but the main difference is that 401(k)s are employer-sponsored, while IRAs are usually opened and funded independently with the help of a bank or broker. The contribution limit for 401(k)s is higher, and you may even be able to borrow money from the account. However, once you leave the employer who sponsored your plan, you can no longer contribute.

Investors typically have more investment options with an IRA. Fidelity is a good choice for beginners, offering no account minimums, commissions-free stock and ETF trades, and many zero-fee index funds. New investors can also start with fractional shares, which are available for as little as $1.

Betterment offers automated trading, rebalancing, and dividend reinvesting, and allows customers to sync outside accounts. It is one of our favorite robo-advisors, with multiple portfolio options, reasonable management fees, and no minimum balance requirements.

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Bottom line

Discovering the specifics of your company's 401(k) plan, including tax benefits and employer contributions, is crucial in choosing the best way to contribute to it.

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