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What Is a 401(k) Plan and How Does It Work? – Limits, Rules & Benefits

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37.0K

Study after study shows that Americans aren’t saving enough for retirement. News articles about this problem usually conclude by urging workers to step up their savings and set aside at least 10% of their income in their workplace 401(k) plan. But is a 401(k) really the best way to invest?

To answer that question, you need to know a little bit about how these plans work. They definitely have advantages, especially when it comes to saving you money on your tax bill. But they also have a few downsides that might make you hesitate about using them for all your investing.

How 401(k) Plans Work

The 401(k) plan takes its name from subsection 401(k) of the U.S. tax code, which deals with workplace retirement plans. This type of plan first emerged in the 1980s as an alternative to traditional pension plans. Up until that time, most large businesses offered pension funds for their employees, which provided them with a steady income in retirement. However, as the cost of pension plans rose, most employers replaced them with 401(k)s, which were funded mainly by contributions from the workers.

Here’s how a 401(k) plan works:

  1. Contribute. You contribute to the fund with pre-tax dollars, which are taken directly out of your paycheck. This reduces your income and therefore lowers your tax bill.
  2. Invest. You can invest the money in a selection of funds. You pay no tax on the money your investments earn as long as they remain in the 401(k).
  3. Withdraw. When you retire, you start withdrawing money from your 401(k). You must pay tax on the money when you withdraw it. However, if your income is lower than it was when you were working, you could pay tax at a lower rate.

There’s also an alternative type of 401(k) plan, called a Roth 401(k), which flips these tax benefits on their head. You fund your account with after-tax dollars, but you pay no tax on the money when you withdraw it.

Both types of 401(k) are workplace plans, so you can invest in one only through your job. Typically, your company won’t run the plan itself; instead, it will hire an investment firm as an administrator. This firm will send you regular statements to tell you how your 401(k) is performing and how much money it contains. If you want to make any changes to your investments, you must call the firm or go through its website.

Pro tip: If your employer offers a 401(k), check out Blooom, an online robo-advisor that analyzes your retirement accounts. Simply connect your account, and you’ll quickly be able to see how you’re doing, including risk, diversification, and fees you’re paying. Plus, you’ll find the right funds to invest in for your situation. Sign up for a free Blooom analysis.

Limits on Contributions

The government offers these tax benefits for 401(k)s because it wants to encourage Americans to save for retirement. However, it doesn’t want them to squirrel away so much of their income before taxes that they end up paying no income tax at all. To prevent this, it sets limits on how much you can contribute to a 401(k) each year.

For 2019, the maximum contribution is $19,000 for most workers. Workers over 50 can make an extra “catch-up” contribution of up to $6,000, for a maximum of $25,000. These catch-up contributions make it easier for older workers to reach their retirement savings goals before they hit retirement age.

Although these are the limits set by law, some employees aren’t allowed to contribute all the way up to the maximum. Some workplace plans impose limits on contributions that are lower than the $19,000 maximum. In addition, owners, managers, and “highly compensated” employees aren’t always allowed to make the maximum pre-tax contribution. The IRS defines highly compensated employees (HCEs) in two ways:

  • The Ownership Test. Any worker who owned at least 5% of the business during the past year or the year before is an HCE.
  • The Compensation Test. Workers are HCEs if they earned at least $80,000 the year before and they earn a higher salary than 80% of the workers at the company.

Required Minimum Distribution

The IRS limits not only how much you can contribute to a 401(k), but also how long you can keep contributing. When you reach retirement age, you must stop putting money into your account and start taking money out. The amount you must withdraw each year is called the required minimum distribution, or RMD.

Exactly when you need to start taking RMDs depends on when you retire. If you retire before you’re 70½ years old, you must start taking RMDs from your 401(k) when you reach this age. If you’re still working when you reach age 70½, you don’t have to take RMDs until you retire.

Your RMD depends on your age and how much money you have in the account. The IRS offers worksheets to calculate your RMD for a given year. If you’d rather not do the math yourself, you can instead use an RMD calculator, such as this one from Schwab.

Advantages of Investing in a 401(k)

Experts generally agree that if you have access to a 401(k) at work, you should be putting money into it. These plans offer many advantages that other investments don’t, including tax savings, convenience, and matching contributions from your employer.

1. You Pay Less in Taxes

The most obvious perk of 401(k) plans is their ability to lower your tax bill. For instance, say you’re currently earning $70,000 per year and paying $8,700 in federal income tax. If you put $7,000 – 10% of your income – into your 401(k), your taxable income drops to $63,000. As a result, your tax bill falls to about $7,160, saving you more than $1,300.

On top of that, you pay no taxes on the money your investments earn. Instead of paying taxes on the dividends you earn, you can keep reinvesting them, tax-free, year after year. To see how fast your retirement savings can grow in a 401(k), check out a 401(k) calculator such as this one from AARP.

2. It Makes Saving Easier

A 401(k) makes saving for retirement easier in two ways. First of all, because you’re using pre-tax dollars, your investments take a smaller bite out of your paycheck. If taxes currently eat up 15% of every dollar you make, you must earn $1,000 to invest $850 in a taxable account. But to invest $850 in your 401(k), you sacrifice only $850 worth of income.

Second, contributions to a 401(k) are automatic. The money comes directly out of your paycheck before you even receive it. There’s nothing to remember and no paperwork to do. And because you never have the money in your hands, you don’t feel like you’re giving up that money to invest it.

3. Your Employer Can Chip In

Although contributions to your 401(k) come mainly out of your paycheck, many employers agree to match a portion of what you contribute. For instance, your employer might offer to match you dollar-for-dollar on the first 3% of your salary that you put into your account. So if you’re earning $70,000, and you contribute 3% of that ($2,100), you get another $2,100 from your employer. Contributions from your employer do not count toward the limit on how much you can invest each year.

If you’re a new employee, the money your employer contributes to your 401(k) doesn’t become yours right away. You must work for the company for a set number of years before these contributions “vest,” or transfer ownership to you. This is done to protect the company from losing its money if you decide to leave your job after only a year. You might have to wait anywhere from three to six years for your employer’s contributions to vest completely.

However, even if you can’t tap into your employer’s contributions right away, they’re still basically free money. Experts agree that if your employer offers 401(k) matching, you should invest at least enough in your 401(k) to get the maximum in matching funds.

4. You Control Your Investments

Old-school pension plans were entirely under the employer’s control. It was the company’s money going into the pension fund, so the company got to decide how to invest it. With 401(k) plans, by contrast, you can choose your own investments to fit your needs and your investing style.

Most 401(k) plans offer an assortment of mutual funds to choose from, covering a mix of stocks, bonds, and money market investments. One popular choice for 401(k) investments is target date funds, which adjust their investment balance to reduce risk as you grow closer to retirement.

5. Your Account Is Transferable

Although you can only invest in a 401(k) through your workplace, that doesn’t mean your plan is tied to your company. If you change jobs, you can roll over your 401(k) into a new account with the same tax advantages. That could be a traditional IRA or another 401(k) with your new employer.

If your company goes out of business, you still don’t lose the money in your 401(k). You probably won’t be able to keep your plan, but you can roll over the money into an IRA and pay no tax on it.

Even if you die, the money in your 401(k) doesn’t disappear. If you’re married, it automatically goes to your spouse. If you’re not, you can name anyone you like – such as a sibling, adult child, or friend –  as a beneficiary, and that person will receive the funds.

Disadvantages of Investing in a 401(k)

All in all, a 401(k) has so many advantages that it sounds like a no-brainer to invest in one if you have the option. However, that doesn’t mean you want to do all of your investing this way. The 401(k) has a couple of drawbacks that should make you cautious about tying up all your money in one.

1. The Money Is Inaccessible

When you put your money in a 401(k), you’re pretty much tying it up until you reach retirement age. Under IRS rules, you’re normally not allowed to withdraw any money from your 401(k) until you reach age 59½. If you do, not only do you owe taxes on the money you withdraw, but you also must pay an extra 10% of the amount as a penalty. For instance, if you’re in the 25% tax bracket and you withdraw $5,000 from your 401(k) early, you’ll owe a total of $1,750 – or 35% – in taxes.

However, there are certain exceptions to this rule. There’s no penalty for withdrawing money early if:

  • You either lose or leave your job at age 55 or later
  • You retire early and take “substantially equal periodic payments” from your 401(k) once a year to help fund your retirement (if you choose this option, you must keep taking the payments for at least five years or until you reach age 59½)
  • You become disabled
  • You need the money to help cover medical expenses that come to more than 10% of your income
  • You need the money to pay for a “qualified domestic relations order” (this usually means paying child support or alimony to a former spouse)
  • You die, and the money in your 401(k) gets paid to your beneficiary

The administrators of 401(k) plans also have the option of waiving the penalty if you suffer some other hardship that requires you to get your hands on a lot of money in a hurry. This allows you to tap your 401(k) for a down payment on a first home, to pay for some types of major repairs to your home, to avoid losing your home to foreclosure or eviction, to pay for college, or to cover funeral expenses. Plans may also grant a hardship exemption if you’re the victim of a disaster such as a severe storm, wildfire, or earthquake. However, your plan doesn’t have to waive the penalty in these cases; it’s up to the plan administrator to decide.

One way to get around this restriction is to borrow from your 401(k) instead of taking an early withdrawal. As long as you pay the money back into the account within five years, you’ll pay no tax or penalty. However, you’ll still have to pay interest and fees on the loan. Also, if you lose your job or change jobs, you must either pay back the loan immediately or treat the balance as a withdrawal, paying all tax and penalties.

The bottom line is that putting your money in a 401(k) makes it much harder to get at it if you need it. That doesn’t mean you shouldn’t invest in your 401(k), but you should take care not to invest too much. Make sure you’re leaving enough money in accessible accounts to meet all your everyday needs and pay for emergencies.

2. Your Investment Choices Are Limited

Although 401(k) plans generally offer different funds for you to invest in, they can only provide a limited number of options. That can be a good thing since too many choices could be overwhelming. It’s easier to choose from an assortment of a dozen funds than to evaluate hundreds of different options.

However, the specific plans your 401(k) offers aren’t always the best possible choices. Sometimes they charge higher fees or earn lower returns than other funds of the same type, such as stocks or bonds. And sometimes your 401(k) doesn’t give you access to a particular type of investment that interests you, such as energy stocks.

Again, this doesn’t mean you shouldn’t put any money in your 401(k), especially if you’re getting matching funds from your employer. But it’s a good reason to think about investing some of your money outside of your 401(k), as well. You won’t be able to use pre-tax dollars, but you’ll have more choices, some of which could give you a better return.

Final Word

If you have access to a 401(k) plan at work, it makes sense to do some of your investing this way. At a minimum, you should put in enough of your salary to take full advantage of any matching funds from your employer.

However, it doesn’t make sense to tie up all your money in your 401(k). You should keep some of it in an emergency fund so you won’t have to tap your 401(k) in a crisis. And if you can spare the cash, it’s also a good idea to put some into taxable accounts, which can offer a wider choice of investments and lower fees.

Of course, all of this is a moot point if your workplace doesn’t offer a 401(k). If you have a job without benefits, look into other retirement plans such as IRAs, which offer similar tax advantages.

Do you invest in a workplace 401(k)? Why or why not?

Amy Livingston
Amy Livingston is a freelance writer who can actually answer yes to the question, "And from that you make a living?" She has written about personal finance and shopping strategies for a variety of publications, including ConsumerSearch.com, ShopSmart.com, and the Dollar Stretcher newsletter. She also maintains a personal blog, Ecofrugal Living, on ways to save money and live green at the same time.

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