Last Updated on November 20, 2024 by Ben
How 401k Works
Congress created the 401(k) plan to help Americans save for retirement. It is a tax-favored way for an employer to offer a retirement plan to its employees. And it is a benefit plan that allows workers to save pretax dollars on their paychecks.
What Is a 401(k) Plan?
The 401(k) plan is the best way to save for retirement with tax advantages. The name originates from the US Internal Revenue Code, which provides for these plans- it’s named after this section!
When employees sign up to participate in the company’s 401(k) plan, they agree that a portion of each paycheck will go into an investment account, with the amount saved pretax. The 401(k) plan itself is not a tax-advantage, but the investment funds inside it are.
How Does a 401k Plan Work?
Participants in a 401(k) plan can choose among investment options offered by their employer and put some or all of their pretax dollars into these options.
The investments are offered by various private financial institutions called financial intermediaries (also called brokers or advisers). The participant has control over the investment options and funds in the account within limits established by the plan.
These options include mutual funds, stock funds, bonds funds, or a combination of these asset classes. There are two main options for how an employee can participate in the plan: “direct” and “indirect”. In a direct 401(k), all contributions to the plan come straight from the employer, and an indirect 401(k) plan allows employees to make direct and pretax contributions.
What are the Benefits of a 401k?
Here are some of the benefits of a 401(k) plan: Participants can deduct the amount they contribute to their 401(k) plan from their federal income taxes. 401(k) plans are exempt from federal income taxes. The 401(k) funds are not included in the value of a taxpayer’s home for tax purposes.
When the participant in a 401(k) plan withdraws contributions before 59 ½, no taxes are due; however, early withdrawal generally incurs a tax penalty. With a 401(k), employees do not have to pay any taxes on earned interest if they do not withdraw their contributions before 59 ½.
Although an “employee’s” 401(k) plan contributions are not counted as earned income, an “employer’s” contributions are subject to Social Security taxes. Most employers pay a “matching” contribution to the 401(k) plan on behalf of their employees.
The matching contribution is usually the same as or greater than the employee’s contribution. In general, the more an employer contributes to a 401(k) plan, the greater the employer’s chance of success.
401(k) Contributions
The maximum amount that a worker or employer can put into a 401(k) plan is adjusted every year to account for inflation. This economic statistic assesses rising prices in a country.
The yearly limit on employer contributions is $16,500 for 2021 and 2022. The purpose of the limits is to guarantee that as many workers as possible can participate in a 401(k). These limits were adjusted in 2011 to $17,500 for workers under 50 and $16,500 for those 50 and over.
Taxes and 401(k) Plans
401(k) plans are not taxed like other retirement plans, including IRAs and pension plans, are taxed. When a taxpayer contributes to a 401(k), they get a tax deduction on the pretax dollars they contributed.
Any funds in the account when the taxpayer reaches age 59 ½ are not taxed. (A taxpayer can also avoid the early-withdrawal tax if at least age 50. However, if a taxpayer withdraws from a 401(k) before age 59 ½, a tax is due.
Employees do not pay taxes on any interest earned in their 401(k) plan accounts. An “employee” for tax law includes any person who performs services for an employer. In general, your employer will be the person who makes 401(k) contributions on your behalf.
401(k) Plan Investments
The most common way to invest in a 401(k) plan is by opening an investment fund, also called a “brokerage” or “plan.” The advantages of investing through your 401(k) plan are that the plan administrators take care of all the paperwork and set up the account. Your employer will often charge you no fees or commissions for investment advice or services.
Taking Withdrawals From a 401(k)
Your account balance at age 70 will be the sum of any employer contributions, interest earned, and any withdrawals that you have made from your 401(k) plan account. With a direct 401(k), withdrawals before age 59 ½ may be subject to a 10 percent early-withdrawal penalty.
With an indirect 401(k), you may be able to avoid the early-withdrawal penalty if the same employer has employed you for at least 10 years. Your employer will probably offer you an age-appropriate form to fill out to request your withdrawal.
You may need to see your employer’s plan document to determine your rights under the plan. With an indirect 401(k), your plan document will probably tell you that you will need to submit a well-written request to your employer for your withdrawal.
The request should contain information about your purpose for withdrawal and your willingness to pay a required IRS tax upon your withdrawal. For example, you may pay a required IRS tax of 10 percent of any withdrawal amount. Your employer will then process your requested withdrawal, which will be sent to you directly.
Final Thoughts – How 401k Works
The 401(k) plan is a valuable and popular form of retirement savings., and it is appropriate for taxpayers over the age of 50 years old and for employers with 50 or more employees. With a 401(k), your employer makes contributions on your behalf, and you have the opportunity to choose where to invest your pre-tax dollars.
The most popular way to invest in your 401(k) account is through a “brokerage” or “plan.” With a direct 401(k), you can generally withdraw your contributions and earnings at any age before age 59 ½ with a 10 percent penalty. However, you may be required to pay a 10 percent tax on the withdrawal amount if you are employed with the same employer for less than 10 years.