What Is a 401(k)?

A 401(k) is an employer-sponsored retirement savings and investment plan. The plan is typically optional and has eligibility requirements, such as participant age and employment timeframe. In a traditional 401(k), money is deducted from an employee's pre-tax pay each pay period and deposited into the designated investment account.

Ideally, investing in a 401(k) means the amount in the account will increase as the years go on, so you’ll have enough to live off of during your retirement years.

How Much Does a 401(k) Pay During Retirement?

A 401(k) isn't guaranteed to pay out a specific amount. Along with the expected rate of return on your investment, the amount you’ll get in retirement depends on several factors, including:

Participants can consult a financial professional for advice or use an online 401(k) retirement calculator for a ballpark estimate based on their circumstances.

How Much Should Someone Contribute to a 401(k)?

The amount you contribute depends on several factors, like your income, other savings plans, current age, and the lifestyle you want in retirement. Many financial professionals recommend contributing as much as you can, maintaining a savings rate of at least 15% of your annual income over the course of your career.

What Does the Average American's Retirement Savings Look Like?

In 2022, the average household retirement savings amount was $87,000. The average American’s retirement savings correlate to their age in the following ways:

Most participants' accounts dwindle as they start to rely on these funds. Consequently, those aged 75 and older have about $130,000 saved. A decrease at that point is normal. After all, what is a 401(k) account if not something you can rely on when you’re older?

What 401(k) Means

The term “401(k)” doesn’t carry any hidden meaning. It’s simply named after section 401 of the US Internal Revenue Code (IRC), which details regulations for qualified pension, profit-sharing, and stock bonus plans.

How Does a 401(k) Work?

A 401(k) is a defined contribution plan in which the employee and employer contribute to the account up to an annual limit set by the IRS. Depending on the type of 401(k) you have, the contribution amount is deducted from your pre- or after-tax income and deposited into an investment account.

This retirement plan is commonly offered through an employer, but self-employed professionals can open one, too.

Employers don’t generally manage the account—it’s usually handled by an outside investment firm. That firm provides participants with various investment options with the ultimate goal of growing their accounts long-term.

Most 401(k) plans allow you to start withdrawing money at age 59 ½. You can draw from your 401(k) sooner, but you’ll likely incur penalties. When you retire, you’ll have several options for withdrawal, including taking a lump sum payment, taking required minimum distributions (RMD), or even converting the plan to an IRA or annuity.

How Employer Matching for a 401(k) Works

Employer matching programs vary by company. This is where an employer contributes the same percentage as that employee, but usually only up to a certain extent. According to Vanguard, the average employer match for a 401(k) program was 4.5% in 2022.

Using this number as an example, here's how this could work:

Among employers that offer 401(k) plans, 95% offered a match program the same year.

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Tax Advantages of a 401(k) Plan

What does a 401(k) do besides collect money? It also provides tax advantages for all parties involved. Employers can deduct contributions that don’t exceed limitations in section 404 of the IRC on their federal income tax returns. Additionally, elective deferrals and investment gains are tax-free until distribution.

Tax advantages for employees depend on the plan, for example:

Traditional 401(k)

With a traditional 401(k) plan, you contribute pre-tax dollars. Depending on how much you contribute, this can significantly reduce your federal and state income tax burden today. However, you must pay taxes on that money once you take qualified distributions.

Roth 401(k)

Contributions to a Roth 401(k) plan are made after taxes. While this does nothing to reduce your tax burden today, your money grows tax-free and you won’t have to pay taxes on it when you withdraw in retirement.

These tax benefits only apply if you’ve had the account for at least five years and you wait until you’re eligible to take distributions.

Different Types of 401(k) Plans: How Much Can I Contribute to My 401(k)?

Regardless of the type of 401(k) plan you have, your maximum elective contributions remain the same. However, these retirement plans differ in other important ways that all employees should be aware of.

Limits and Matching Rules for 401(k) Accounts

For 2023, the maximum contribution limit is $22,500 for each employee. Catch-up contributions of $7,500 are allowed for participants age 50 and older, bringing the maximum contribution for employees in that age bracket to $30,000.

Contributions made by the employee and the employer collectively may not exceed $66,000 (or $73,500 for employees over age 50). Total contributions also cannot exceed 100% of an employee's yearly salary.

Rules for Employers

Employers enacting matching programs must abide by certain rules, such as:

At What Age Is 401(k) Withdrawal Tax-Free?

401(k) withdrawals generally become tax-free at age 59 ½. However, this only applies to those with a Roth 401(k). Traditional 401(k) owners who didn’t pay taxes on the front end will owe them in the distribution phase of the plan.

How to Withdraw from a 401(k)

In most cases, you’ll simply log into your account (or contact your plan sponsor or account administrator) and fill out the correct form. Some investment firms allow you to request a one-time cash distribution or set up a plan that makes automatic recurring payments.

How to Borrow or Cash Out From 401(k)

In some circumstances, you may be able to take money out of your 401(k) account before you reach the eligibility age. Hardship withdrawals can be approved for things like:

Some 401(k) plans also support withdrawals for non-hardship reasons.

A 401(k) loan is another option. You’re generally required to pay the money back with interest within five years, but you can borrow up to 50% of your vested account balance (with an IRS-imposed limit of $50,000 minus any outstanding loan balances during the prior 12-month period). Fortunately, you don’t have to pay taxes or penalties when the loan is originated, and the interest goes into your retirement account.

Requesting a hardship distribution or loan involves talking to your plan sponsor and filling out the correct form. You’ll likely be required to submit documentation that explains what you’ll use the money for.

401(k) Penalties to Know

While early 401(k) withdrawals (before age 59 ½) don’t always need to be repaid, each one is taxed as income and subject to a 10% penalty. This means you may have to take even more to cover your actual expenses. There are some exceptions to this, such as qualified higher education expenses or cases of total disability. Penalties also apply to 401(k) loans if you default.

What Happens to a 401(k) When You Leave Your Job?

When you leave your job, your 401(k) typically stays with you. However, you can do something else with it, such as:

If you have less than $5,000 invested, your old employer may choose not to keep your 401(k). In this case, they may cash it out and send you a check or roll it into an IRA on your behalf.

How to Roll Over a 401(k)

401(k) rollovers are usually through direct transfer, which means the funds move directly from your old account to the new one.

You can also do an indirect transfer. In this case, your old plan administrator mails you a check for the account balance. You must then deposit that check into a new account within 60 days to avoid taxes and penalties. During the indirect transfer, your old employer must hold back 20% of your balance to pay federal (and possibly state) income taxes.

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