What is a 401(k)?

How does a 401(k) work?

When you participate in your employer's 401(k) plan, you choose the percentage of your income that you want to contribute from each paycheck before any taxes are taken out.

In 2023, you can contribute a maximum of $22,500 from your pre-tax pay if you're under 50. If you're 50 or older, you can put in as much as $30,000. The extra $7,500 "catch-up contribution" is meant to help boost your retirement savings when you're coming down to the wire.

Making it your goal to contribute the max each year will put you on the right path toward having enough savings for a comfortable retirement.

A 401(k) gives you a tax break because you don't pay tax on your contributions or investment earnings until you make withdrawals during retirement — when you're more likely to be in a lower tax bracket.

There's a strong incentive to keep you from touching your 401(k) money too soon. If you make a withdrawal before you reach 59.5 years of age, you'll usually owe a 10% penalty, plus income tax on the amount taken out.

However, there are a few exceptions to the rule. You can qualify for a “hardship withdrawal” if you need to pay for medical or funeral expenses.

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The 401(k) employer match

Here's more about the free money from the boss: Some employers match workers' 401(k) contributions, up to a certain percentage of their salaries. The average employer match is now a record maximum of 6%, according to Fidelity Investments.

When your employer matches, you want to try contributing at least the percentage of your pay that will be matched. So if the match is 5% where you work, you want to be sure that at least 5% of your salary is going into your 401(k).

Many companies match dollar for dollar up to the threshold, though many others give just 50 cents for each $1 a worker contributes.

Let's say your employer is one of the more generous ones and fully matches every dollar.

If you earn $60,000 a year and contribute 10% to your 401(k), you're putting $6,000 into your account annually. The company matches you up to 6% of your $60,000 salary, meaning it contributes $3,600 — a great perk.

An employer matching 50 cents on the dollar under that same scenario would contribute half as much: $1,800.

How your 401(k) money is invested

Workers typically have a variety of investments to choose from within their 401(k)s. These might include index funds, other mutual funds, individual stocks and bonds and maybe even company stock.

You choose the risk level for your portfolio, based on your goals, assets and the other retirement savings that you might have.

In general, younger people can stand to carry more risk because they have a longer time to invest.

As you draw closer to retirement, you'll want to readjust your portfolio to make it more conservative, so you can preserve as much of your savings as possible.

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401(k) rollovers and RMDs

So, what if you have a 401(k) and you decide it's time to change jobs? You can:

• Leave your 401(k) right where it is, at your old company.
• Cash it out, albeit with income taxes on the lump sum.
• Roll it over into a 401(k) at your new job.
• Roll it over into an IRA, or individual retirement account. An IRA is similar to a 401(k) in many ways, though it's not tied to an employer.

If your previous employer allows you to keep your account with them, you might enjoy the convenience of leaving everything as is. Seems like the easiest solution, right? However, Ameriprise Financial notes that American workers lose track of billions of dollars in old retirement accounts. Some things you should consider before deciding to leave your 401(k) with a former employer includes: the amount of money you have in the account and any additional maintenance and transaction fees that may affect your long-term returns.

Cashing out your 401(k) comes with paying income taxes on the lump sum, which might not be ideal for many Americans. Therefore, rolling over your 401(k) can be a good idea because that will make it easier for you to keep track of your retirement savings.

A rollover is a direct transfer of funds from one retirement plan to another (or an IRA) — it's not a withdrawal. So there are no penalties, fees or taxes to worry about. Rolling over your 401(k) into a new employer’s plan is a great way to keep track of your retirement savings.

However, if you’re looking for a wider range of investment opportunities, rolling your 401(k) over into an IRA might be the better option. It will allow you the flexibility to control your savings rather than relying on an employer’s plan. You’ll just need to remember that the IRS only gives you 60 days from the date you receive a retirement plan distribution to roll it over into another plan or IRA.

Once you reach 72 years of age, 401(k) withdrawals become mandatory. When you don't take your annual "required minimum distributions" (RMDs), you face a stiff tax penalty equal to 50% of the amount that should have been withdrawn.

What's a Roth 401(k)?

A 401(k) cuts your tax bill now and pushes those taxes down the road, to your retirement years. That strategy makes sense if you believe your income will be lower in retirement.

But if you think it's likely you'll have a higher income in retirement, a Roth 401(k) might be a smarter choice than the usual garden-variety 401(k). You'll want to see if your company offers the Roth option, which switches the taxes around.

With a Roth 401(k), the money that you contribute comes from the portion that has already been taxed. When you retire, you pay no taxes on your withdrawals — including your investment earnings.

However, a Roth 401 (k) also has mandatory minimum withdrawals, which are known as “required minimum distributions.” The RMDs start once you hit 72.

Pensions vs. 401(k) plans

The 401(k) plan gets its name from the section of the tax code that helped create the accounts in the 1980s. Companies saw an opportunity to offer their employees tax-advantaged savings accounts that were less expensive than pensions.

Pension plans used to be fairly common. When a company has a pension, it invests money on behalf of its employees so it can provide them with income in retirement.

In 1998, 59% of Fortune 500 companies were offering their employees pension plans. By 2017 only 16% were, according to a 2020 report from consulting firm Willis Towers Watson.

Pensions offer set amounts of money that retirees can count on (unless the employer goes belly-up). With 401(k) plans, what you receive depends on your contributions and the performance of your portfolio.

But a 401(k) gives you more control over your retirement savings. Contributing to a 401(k) plan through your job can be a good way to painlessly set money aside for your later years, save on taxes and get a little bit more from your boss.