What Is A 401k? How It Works And Basic Rules

What is a 401k?

A 401k is an employer-sponsored retirement savings plan. Employees can contribute a part of their paycheck each month, and companies may choose to match contributions up to a certain limit (ex. A dollar-for-dollar employer match up to 5% of an employee’s salary each year).

Contributions to your 401k get invested (usually into mutual funds) and grow with tax-free compounding until you make withdrawals in retirement.

How does a 401k work?

If your company offers a 401k plan, you can choose to contribute a percentage of your paycheck into your account each month. Contributions are automatically withdrawn from your pay and get invested into a selection of mutual funds, chosen by your employer.

A company isn’t legally obligated to offer a 401k plan to their employees. It’s mainly offered as a benefit to attract top talent.

Based on which 401k account you contribute to, you can either get a tax advantage when you contribute (through a traditional 401k), or when you withdraw (through a Roth 401k). 

Traditional 401k vs Roth 401k

A 401k plan has two options: A traditional 401k and a Roth 401k. Not all companies offer a Roth option, but if they do, you could choose to delay your tax advantage until retirement.

Traditional 401k contributions are deducted from gross income. The money is deducted from your payroll before you pay any income taxes. For example, if you make $60,000 this year and decide to contribute $10,000 into your traditional 401k, your new taxable income would be $50,000 ($60,000 minus $10,000).

Roth 401k contributions are deducted from after-tax income. Continuing with the same example, if you contributed $10,000 after making $60,000 in income, your taxable income would still be $60,000. While you get no immediate tax benefit, any withdrawals from your account in retirement are tax-free.

For example, if your $10,000 contribution grows to $100,000 by retirement…

Employer matching contributions

Some companies offer employer matching contributions, where your employer will match your contributions dollar-for-dollar or 50 cents on the dollar, up to a specified percentage of your salary.

For example, your employer match your contributions dollar-for-dollar up to 5% of your salary. If you make $100,000, you could get an employer match of $5,000 if you also contribute at least that amount.

Many employees consider employer matches as free money on top of their salaries, and it’s a good idea to contribute at least enough to your 401k to get the full employer match each year. Both traditional and Roth contributions count towards employer matches. However, your employer contributions will always be in pre-tax dollars to a traditional 401k. Employers cannot contribute into a Roth account.

Also read: 30 Companies With The Highest Employer Match

Who is eligible for a 401k?

A 401k is employer-sponsored. To have a 401k plan to contribute to, you need to work for a company that offers a 401k. Eligibility rules are different depending on the company policies, but in general, the IRS requires any employee that meets the following requirements to start receiving a 401k plan.

You cannot set up a 401k as an individual like you could with an IRA. Self-employed individuals can set up a solo 401k if they have no full-time employees.

Are there any age limits?

A company can choose to offer a 401k to employees that are under 21 years of age, but are not obligated to do so. There is no maximum age for a 401k; a company cannot exclude any employees that have reached a certain age.

Contribution limits

How much can you contribute to a 401k?

The IRS sets limits on how much employees can contribute to a 401k each year. Because a 401k is tax-advantaged, you’re not allowed to contribute more money into your plan than the yearly limit.

Total contributions must not exceed your pay. For example, if you only $15,000 this year, the maximum you can contribute to your account is $15,000.

Can I contribute to both a traditional 401k and Roth 401k?

Yes. If your employer offers both options, you can contribute to both plans. You can choose how much to contribute to each account, but your total contributions must not exceed the yearly contribution limit, and must not exceed your salary.

For example, if you made enough to contribute the full $22,500 limit for 2023, you could choose to contribute half to a traditional account and half to a Roth account. Your contributions to your traditional account would get deducted from your taxable income. Your contributions to your Roth account would be taxed as regular income when you contribute.

Contribution deadlines

The contribution deadline of a 401k is December 31, each year.

401k withdrawal rules

When can you take money out of a 401k?

You’re eligible to start taking qualified distributions from your 401k when you reach the age of 59½. Any early withdrawals are subject to a 10% early distribution penalty plus income taxes on the amount withdrawn.

Required minimum distributions (RMD)

A 401k also has required minimum distributions. When you reach the age of 72, you must start taking distributions from your account each year, until emptied.

What if I leave my company?

If you leave your employer, your 401k can be rolled over into another retirement account such as an IRA, solo 401k, or a 401k plan with a new employer.

Also read: Direct vs Indirect Rollovers

Advantages of a 401k

Employer matching contributions

A 401k isn’t generally the best retirement plan available. Something like a solo 401k gives you more contribution room and a wider selection of investment options. However, a 401k can offer something that other retirement plans can’t: employer matching contributions.

Also read: What Is The Average 401k Employer Match?

Tax deductions

Making contributions to a 401k can reduce your income taxes each year. If you contribute money to a traditional 401k, your contributions get deducted from your taxable income.

Tax-free compounding

Investments in a 401k grow tax-free until retirement. When you sell assets for a profit in your account, you don’t have to pay any capital gains tax and can reinvest all the gains back into your 401k. With a traditional 401k, you only pay taxes when you make withdrawals in retirement. With a Roth 401k, you don’t pay any taxes in retirement.

Investing in a 401k is hassle-free

With a 401k, your contributions are automatically deducted from your paycheck each money. Once you decide what percentage of your pay to contribute, there’s no more effort required on your part to save for your future. It’s a reliable way to invest for people who struggle to take the initiative to save on their own.

Disadvantages of a 401k

Limited investment options

The biggest downside of a 401k is that your investment options are limited. Usually, your options consist of around a dozen mutual funds. You can’t invest in individual stocks or alternative assets like crypto and real estate. With an IRA, you have a wider selection of mutual funds, ETFs, bonds, and you can even invest in individual stocks. With a solo 401k, you can get full checkbook control over your account and invest in any asset class, including real estate, crypto, and private equity and venture capital.

What can you invest in through a 401k?

Your investment options in a 401k are limited to whatever your employer decided when they set up the plan. A typical 401k plan usually has around 8 to 12 mutual funds you can select from. If you work for a public company, you may also be able to invest in the company stock.

Can a 401k invest in alternative assets?

No, a corporate 401k typically does not have any other investment options besides a small selection of mutual funds. You cannot invest in alternative investments like crypto, real estate, or private equity.

Are traditional and Roth 401k investment options the same?

Yes. Your investment options are the same whether you’re investing through a traditional 401k or Roth 401k. The only difference between the two accounts is when they get taxed.

Are 401k contributions tax deductible?

Yes, but only for contributions made to a traditional 401k. Roth contributions are not tax deductible. When you contribute any money to a traditional 401k, it gets deducted from your taxable income for the year. Roth contributions are made in after-tax dollars after you already pay income taxes.

Is a 401k the same thing as a pension plan?

No, a pension plan and 401k are different things. Pensions are defined-benefit plans and are funded and controlled by the employer. A 401k is primarily funded by employee contributions.

With a pension, employers fund and guarantee a monthly check in retirement. You can only receive your pension if you stay with the company until you reach retirement. It cannot be rolled over to another retirement plan like a 401k.

Pensions used to be common, but are falling in popularity as they’ve become replaced by the 401k.