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What is a 401(k)?

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1 minutes

A 401(k) is a tax-advantaged retirement savings plan offered by employers in the United States, allowing employees to contribute a portion of their salary into an investment account, often with employer matching contributions. The funds grow tax-deferred until withdrawal, typically during retirement.

401(k) vs. other investment accounts

If you’re planning for retirement, you’re probably wondering how a 401(k) compares to other investment options. The 401(k) offers unique tax advantages, particularly in how contributions and earnings are treated, which might make it a more attractive option than other accounts depending on your financial goals.

401(k) vs. pension

Pension: A retirement plan typically funded and managed by an employer, where the employee receives a fixed monthly benefit upon retirement. The amount is usually based on salary and years of service.

401(k): A defined contribution plan, meaning the employee (and sometimes the employer) contributes money into the account, but the retirement benefits depend on the investment options chosen and the account's performance. 

Pensions provide guaranteed income. On the other hand, 401(k)s offer more flexibility and potential growth, but also come with investment risks.

401(k) vs. IRA

Both 401(k)s and IRAs (Individual Retirement Accounts) are tax-advantaged retirement accounts, but they differ in contribution limits, tax treatment, and eligibility.

A 401(k) is typically employer-sponsored, allows higher contribution limits, and often includes employer matching contributions.

An IRA, which can be a traditional or Roth IRA, is opened independently by the individual, offering more investment options but lower contribution limits. A Roth IRA, specifically, offers tax-free withdrawals in retirement, unlike a traditional 401(k), where withdrawals are taxed. The choice between a 401(k) and an IRA often depends on whether the account holder needs higher contribution limits or wants employer contributions.

401(k) vs. brokerage account

A brokerage account is a taxable account where you can buy and sell a wide range of investments, such as stocks, bonds, and mutual funds. Unlike a 401(k), contributions to a brokerage account are not tax-advantaged, meaning you pay taxes on dividends, interest, and capital gains each year. However, brokerage accounts offer more flexibility in terms of investment options and access to funds, making them useful for short- to medium-term financial goals, while a 401(k) is typically more suited for long-term retirement savings due to its tax benefits and penalties for early withdrawal.

Who is a 401(k) for?

A 401(k) is designed for employees in America who want to save for retirement while taking advantage of tax benefits. It is particularly beneficial for those whose employers offer matching contributions, as this essentially provides free money toward retirement savings.

The 401(k) is suitable for individuals who are willing to invest their contributions in a range of funds, understanding that their retirement income will depend on how their investments perform.

Pros and cons of a 401(k)

Pros of a 401(k)

Cons of a 401(k)

Tax advantages. Contributions to a traditional 401(k) reduce taxable income in the year they are made, and earnings grow tax-deferred until withdrawal. Roth 401(k) contributions are made with after-tax dollars, but withdrawals in retirement are tax-free.

Investment risk. The value of a 401(k) depends on how the chosen investments perform, which means there is a risk of losing money.

Employer matching. Many employers match a portion of employee contributions, which can significantly increase retirement savings.

Limited investment opportunities. Employees are typically limited to the investment options provided by their 401(k) plan, which may not offer the best-performing or lowest-cost funds.

High contribution limits. 401(k)s allow for higher annual contributions compared to IRAs, providing an opportunity to save more for retirement.

Early withdrawal penalties. Withdrawing funds from a 401(k) before age 59½ typically incurs a 10% penalty, in addition to income taxes on the withdrawal amount.

How does a 401(k) work?

Now that you know what a 401(k) is, how does it work?

A 401(k) is a retirement savings plan that allows employees to contribute a portion of their salary into a tax-advantaged account, often with matching employer contributions. This type of plan is known as a defined contribution plan, meaning that the retirement benefits are based on the amount contributed and the performance of the investments chosen.

Americans use 401(k) plans as a primary method for building retirement savings, typically through employer-sponsored programs. Depending on the type of plan, employee contributions can be made on a pre-tax basis, meaning they reduce the employee’s taxable income for the year. The contributions then grow tax-deferred, with taxes paid only upon withdrawal in retirement.

Employer contributions to your 401(k) may be subject to a vesting schedule, meaning you need to remain employed with the company for a certain period before you fully own those contributions.

What is a traditional 401(k)?

A traditional 401(k) is a type of retirement savings account where contributions are made with pre-tax dollars, reducing your current taxable income. The funds grow tax-deferred, and you pay income tax on withdrawals during retirement.

  • Plan contribution limits: For 2024, the annual contribution limit is $23,000 for individuals under 50. Those 50 and older can make an additional catch-up contribution of $7,500, for a total annual contribution of $30,500.
  • Employer matching: Cannot exceed the lesser of $69,000 for individuals under 50 (pr $76,500 for those 50 and up) or 100% of the employee’s annual compensation.
  • Required minimum distributions (RMDs): Once you reach age 73, you are required to start taking minimum distributions from your traditional 401(k) each year. The amount is calculated based on your life expectancy.

Pros and cons of a traditional 401(k)

Pros of a traditional 401(k)

Cons of a traditional 401(k)

Contributions reduce your gross income, lowering your taxable income in the year they are made.

You must begin taking required minimum distributions at age 73, whether you need the funds or not.

Many plans include employer matching contributions, which can significantly boost your retirement savings.

All withdrawals during retirement are subject to income tax, potentially reducing your retirement income.

Traditional 401(k) plans allow for higher annual contributions compared to other retirement accounts.

Investment choices are typically limited to the options provided by your employer’s plan.

What is a Roth 401(k)?

A Roth 401(k) is similar to a traditional 401(k) but with a key difference in tax treatment. Contributions to a Roth 401(k) are made with after-tax dollars, meaning they do not reduce your current taxable income. However, withdrawals during retirement are tax-free, provided certain conditions are met.

  • Plan contribution limits: For 2024, the annual contribution limit is $23,000 for individuals under 50. Those 50 and older can make an additional catch-up contribution of $7,500, for a total annual contribution of $30,500.
  • Employer matching: Cannot exceed the lesser of $69,000 for individuals under 50 (pr $76,500 for those 50 and up) or 100% of the employee’s annual compensation.
  • Required minimum distributions (RMDs): None.

Pros and cons of a Roth 401(k)

Pros of a Roth 401(k)

Cons of a Roth 401(k)

Qualified distributions during retirement are tax-free, which can be a significant benefit if you expect to be in a higher tax bracket in retirement.

Contributions to a Roth 401(k) do not reduce your current taxable income.

Since contributions are made with after-tax dollars, they do not impact your current tax situation.

Investment choices are typically limited to the options provided by your employer’s plan.

How do you start a 401(k)?

Individuals generally can’t start a 401(k) on their own—you need to enroll in your employer’s retirement plan during the onboarding process or an open enrollment period. Eligibility requirements vary by employer, but most plans allow employees to begin contributing once they have met certain employment criteria, such as a specific length of service. 

To enroll, you’ll need to fill out the necessary forms provided by your employer, choose your contribution rate, and select your investment options from those offered within the plan.

How does a 401(k) earn money?

A 401(k) earns money through the growth of the investments chosen by the plan participants.

These can include:

  • Mutual funds
  • Target date funds
  • Stocks
  • Bonds
  • Other securities

The account balance grows over time as the account investments generate returns, such as dividends or capital gains. The specific investment strategy you choose, based on your risk tolerance and retirement goals, will influence how much your 401(k) earns. Diversified investments can help manage risk and maximize growth potential over the long term.

How and when do you withdraw from a 401(k)?

Withdrawals from a 401(k) are, as a rule, only allowed once the account owner reaches age 59½, though plan participants may take early withdrawals under certain conditions—often with penalties.

Qualified distributions from traditional 401(k) accounts are taxed as ordinary income, while qualified distributions from Roth accounts are tax-free.
All IRS rules about 401(k) distributions (and their tax treatment) can be found in Publication 575, Pension and Annuity Income.

Frequently asked questions about 401(k)s

Still have questions about 401(k)s? Learn more in the FAQs below.

Can you take early withdrawals from a 401(k)?

You can take early withdrawals from a 401(k), but it’s important to understand the potential penalties and tax implications. Generally, withdrawing funds before age 59½ will result in a 10% early withdrawal penalty in addition to the regular income tax on the withdrawn amount. However, there are exceptions for specific circumstances, such as a hardship withdrawal, which may allow you to avoid the penalty but still require you to pay income taxes on the amount. Consulting with a financial advisor before taking an early withdrawal can help you understand your options and minimize financial consequences.

What happens to your 401(k) if you leave your job?

If you leave your job, you have several options for your 401(k). You can leave the funds in your former employer’s plan, if allowed, or you can roll over the balance into a new employer’s 401(k) plan or an IRA. Rolling over your 401(k) can help you consolidate your retirement savings and maintain control over your investments, but it’s important to handle the rollover process correctly to avoid taxes and penalties.

Are 401(k)s taxed?

If you have a traditional 401(k), you make pre-tax contributions, allowing your investments to grow until you withdraw them in retirement (also known as tax deferral). Upon withdrawal, the funds are taxed as ordinary income. 

If you have a Roth 401(k), contributions are made with after-tax dollars, so withdrawals during retirement are tax-free, provided certain conditions are met.

What is a solo 401(k)?

A Solo 401(k) is a retirement savings plan designed for self-employed individuals or small business owners with no full-time employees other than the business owner and their spouse. This plan allows for higher contribution limits than traditional 401(k) plans because the business owner can contribute both as an employer and an employee. A Solo 401(k) can be an excellent option for small business owners looking to maximize their retirement savings.

Rippling and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any related activities or transactions.

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