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What Is a 401(k) and

How Does It Work?

What you need to know about the two basic

types—traditional and Roth
By JASON FERNANDO Updated July 19, 2022
Reviewed by ROGER WOHLNER
Fact checked by KATRINA MUNICHIELLO

Table of Contents
What Is a 401(k) Plan?

How 401(k) Plans Work

Contributions

How Does a 401(k) Earn

Money?

Withdrawals

Required Minimum
Distributions Advertisement

Traditional 401(k) vs. Roth

401(k)

When You Leave Your Job

401(k) FAQs

The Bottom Line

Investopedia / Ellen Lindner

What Is a 401(k) Plan?

A 401(k) plan is a retirement savings plan offered by many American employers
that has tax advantages for the saver. It is named after a section of the U.S.
Internal Revenue Code (IRC).

The employee who signs up for a 401(k) agrees to have a percentage of each
paycheck paid directly into an investment account. The employer may match
part or all of that contribution. The employee gets to choose among a number
of investment options, usually mutual funds.

KEY TAKEAWAYS
A 401(k) plan is a company-sponsored retirement account to which
employees can contribute income, while employers may match
contributions.
There are two basic types of 401(k)s—traditional and Roth—which
differ primarily in how they're taxed.
With a traditional 401(k), employee contributions are pre-tax, meaning
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they reduce taxable income, but withdrawals are taxed. [1]
Employee contributions to Roth 401(k)s are made with after-tax
income: There's no tax deduction in the contribution year, but
withdrawals are tax free. [1]
Employer contributions can be made to both traditional and Roth
401(k) plans.

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1:57

Introduction To The 401(K)

How 401(k) Plans Work Advertisement

The 401(k) plan was designed by the United States Congress to encourage
Americans to save for retirement. Among the benefits they offer is tax savings.

There are two main options, each with distinct tax advantages.

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Traditional 401(k)
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With a traditional 401(k), employee contributions are deducted from gross
income, meaning the money comes from the employee's payroll before income
taxes have been deducted. As a result, the employee's taxable income is
reduced by the total amount of contributions for the year and can be reported
as a tax deduction for that tax year. No taxes are due on either the money
contributed or the investment earnings until the employee withdraws the
money, usually in retirement. [1]

Roth 401(k)
With a Roth 401(k), contributions are deducted from the employee's after-tax
income, meaning contributions come from the employee's pay after income
taxes have been deducted. As a result, there is no tax deduction in the year of
the contribution. When the money is withdrawn during retirement, no
additional taxes are due on the employee's contribution or the investment
earnings. [1]

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However, not all employers offer the option of a Roth account. If the Roth is
offered, the employee can pick one or the other (traditional 401(k)) or both.
They can contribute to both, up to annual limit allowed.

Contributing to a 401(k) Plan AIU Pa ial Scholarships

A 401(k) is a defined contribution plan. The employee and employer can make Partial Scholarship available for
those who qualify AIU
contributions to the account up to the dollar limits set by the Internal Revenue
Service (IRS). Open

A defined contribution plan is an alternative to the traditional pension, known

as a defined-benefit plan. With a pension, the employer is committed to
providing a specific amount of money to the employee for life during
retirement.

In recent decades, 401(k) plans have become more common, and traditional
pensions have become rare as employers have shifted the responsibility and
risk of saving for retirement to their employees.

Employees also are responsible for choosing the specific investments within
their 401(k) accounts from a selection that their employer offers. Those
offerings typically include an assortment of stock and bond mutual funds and
target-date funds designed to reduce the risk of investment losses as the
employee approaches retirement.

They may also include guaranteed investment contracts (GICs) issued by

insurance companies and sometimes the employer's own stock.

Contribution Limits
The maximum amount that an employee or employer can contribute to a
401(k) plan is adjusted periodically to account for inflation, which is a metric
that measures rising prices in an economy.

For 2022, the annual limit on employee contributions is $20,500 per year for
workers under age 50. However, those aged 50 and over can make a $6,500
catch-up contribution. [2] [3]

For 2023, the annual limit on employee contributions is $22,500 per year for
workers under age 50. Moreover, those aged 50 and over can make a $7,500
catch-up contribution. [4]

If the employer also contributes or if the employee elects to make additional,

non-deductible after-tax contributions to their traditional 401(k) account, there
is a total employee-and-employer contribution amount for the year:

2022

For workers under 50 years old, the total employee-employer contributions

cannot exceed $61,000 per year. [2]
If the catch-up contribution for those 50 and over is included, the limit is
$67,500. [2]

2023

For workers under 50 years old, the total employee-employer contributions

cannot exceed $66,000 per year. [5]
If the catch-up contribution for those 50 and over is included, the limit is
$73,500. [5]

Employer Matching
Employers who match employee contributions use various formulas to
calculate that match.

For instance, an employer might match 50 cents for every dollar that the
employee contributes, up to a certain percentage of salary.

Financial advisors often recommend that employees contribute at least

enough money to their 401(k) plans to get the full employer match.

Contributing to Both a Traditional and a Roth 401(k)

If their employer offers both types of 401(k) plans, an employee can split their
contributions, putting some money into a traditional 401(k) and some into a
Roth 401(k).

However, their total contribution to the two types of accounts can't exceed the
limit for one account (such as $20,500 for those under age 50 in 2022 or $22,500
in 2023). [4] [2] [3]

Important: Employer contributions can be made to a traditional

401(k) account and a Roth 401(k). In both instances, contributions
and their earnings will be subject to tax upon withdrawal. [6]

How Does a 401(k) Earn Money?

Your contributions to your 401(k) account are invested according to the choices
you make from the selection your employer offers. As noted above, these
options typically include an assortment of stock and bond mutual funds and
target-date funds designed to reduce the risk of investment losses as you get
closer to retirement.

How much you contribute each year, whether or not your company matches
your contributions, your investments and their returns, plus the number of
years you have until retirement all contribute to how quickly and how much
your money will grow.

Provided you don't remove funds from your account, you don't have to pay
taxes on investment gains, interest, or dividends until you withdraw money
from the account after retirement (unless you have a Roth 401(k), in which case
you don't have to pay taxes on qualified withdrawals when you retire).

What's more, if you open a 401(k) when you are young, it has the potential to
earn more money for you, thanks to the power of compounding. The benefit
of compounding is that returns generated by savings can be reinvested back
into the account and begin generating returns of their own.

Over a period of many years, the compounded earnings on your 401(k) account
can actually be larger than the contributions you have made to the account. In
this way, as you keep contributing to your 401(k), it has the potential to grow
into a sizable chunk of money over time.

Taking Withdrawals From a 401(k)

Once money goes into a 401(k), it is difficult to withdraw it without paying taxes
on the withdrawal amounts.

"Make sure that you still save enough on the outside for emergencies and
expenses you may have before retirement," says Dan Stewart, CFA®, president
of Revere Asset Management Inc., in Dallas. [7] "Do not put all of your savings
into your 401(k) where you cannot easily access it, if necessary."

The earnings in a 401(k) account are tax deferred in the case of traditional
401(k)s and tax free in the case of Roths. When the traditional 401(k) owner
makes withdrawals, that money (which has never been taxed) will be taxed as
ordinary income. Roth account owners have already paid income tax on the
money they contributed to the plan and will owe no tax on their withdrawals as
long as they satisfy certain requirements. [1]

Both traditional and Roth 401(k) owners must be at least age 59½—or meet
other criteria spelled out by the IRS, such as being totally and permanently
disabled—when they start to make withdrawals to avoid a penalty. [8]

This penalty is usually an additional 10% early distribution tax on top of any
other tax they owe. [8]

Some employers allow employees to take out a loan against their contributions
to a 401(k) plan. The employee is essentially borrowing from themselves. If you
take out a 401(k) loan, please consider that if you leave the job before the loan
is repaid, you'll have to repay it in a lump sum or face the 10% penalty for an
early withdrawal.

Required Minimum Distributions (RMDs)

Traditional 401(k) account holders are subject to required minimum
distributions (RMDs) after reaching a certain age. (Withdrawals are often
referred to as distributions in IRS parlance.)

After age 72, account owners who have retired must withdraw at least a
specified percentage from their 401(k) plans that is based on their life
expectancy at the time. Prior to 2020, the RMD age was 70½ years old. [1]

Note that distributions from a traditional 401(k) are taxable. Qualified

withdrawals from a Roth 401(k) are not. [1]

FAST FACT
Roth IRAs, unlike Roth 401(k)s, are not subject to RMDs during the
owner's lifetime. [9]

Traditional 401(k) vs. Roth 401(k)

When 401(k) plans became available in 1978, companies and their employees
had just one choice: the traditional 401(k). [10] Then in 2006, Roth 401(k)s
arrived. Roths are named for former U.S. Senator William Roth of Delaware, the
primary sponsor of the 1997 legislation that made the Roth IRA possible. [11]

While Roth 401(k)s were a little slow to catch on, many employers now offer
them. So the first decision employees often have to make is choosing between
a Roth and a traditional (40l(k).

As a general rule, employees who expect to be in a lower marginal tax bracket

after they retire might want to opt for a traditional 401(k) and take advantage
of the immediate tax break.

On the other hand, employees who expect to be in a higher bracket after

retiring might opt for the Roth so that they can avoid taxes on their savings
later. Also important—especially if the Roth has years to grow—is that, since
there is no tax on withdrawals, all the money that the contributions earn over
decades of being in the account is tax free.

As a practical matter, the Roth reduces your immediate spending power more
than a traditional 401(k) plan. That matters if your budget is tight.

Since no one can predict what tax rates will be decades from now, neither type
of 401(k) is a sure thing. For that reason, many financial advisors suggest that
people hedge their bets, putting some of their money into each.

When You Leave Your Job

When you leave a company where you've been employed and you have a
401(k) plan, you generally have four options:

1. Withdraw the Money

Withdrawing the money is usually a bad idea unless you urgently need the
cash. The money will be taxable in the year it's withdrawn. You will be hit with
the additional 10% early distribution tax unless you are over 59½, permanently
disabled, or meet the other IRS criteria for an exception to the rule. [12]

In the case of a Roth 401(k), you can withdraw your contributions (but not any
profits) tax free and without penalty at any time as long as you have had the
account for at least five years. Remember, however, that you're still diminishing
your retirement savings, which you may regret later.

2. Roll Your 401(k) into an IRA

By moving the money into an IRA at a brokerage firm, a mutual fund company,
or a bank, you can avoid immediate taxes and maintain the account's tax-
advantaged status. What's more, you will be able to select from among a wider
range of investment choices than with your employer's plan. [13]

The IRS has relatively strict rules on rollovers and how they need to be
accomplished, and running afoul of them is costly. Typically, the financial
institution that is in line to receive the money will be more than happy to help
with the process and prevent any missteps.

Warning: Funds withdrawn from your 401(k) must be rolled over to

another retirement account within 60 days to avoid taxes and
penalties. [13]

3. Leave Your 401(k) With the Old Employer

In many cases, employers will permit a departing employee to keep a 401(k)
account in their old plan indefinitely, though the employee can't make any
further contributions to it. This generally applies to accounts worth at least
$5,000. In the case of smaller accounts, the employer may give the employee
no choice but to move the money elsewhere.

Leaving 401(k) money where it is can make sense if the old employer's plan is
well managed and you are satisfied with the investment choices it offers. The
danger is that employees who change jobs over the course of their careers can
leave a trail of old 401(k) plans and may forget about one or more of them.
Their heirs might also be unaware of the existence of the accounts.

4. Move Your 401(k) to a New Employer

You can usually move your 401(k) balance to your new employer's plan. As with
an IRA rollover, this maintains the account's tax-deferred status and avoids
immediate taxes.

It could be a wise move if you aren't comfortable with making the investment
decisions involved in managing a rollover IRA and would rather leave some of
that work to the new plan's administrator.

How Do You Start a 401(k)?

The simplest way to start a 401(k) plan is through your employer. Many
companies offer 401(k) plans and some will match part of an employee's
contributions. In this case, your 401(k) paperwork and payments will be
handled by the company during onboarding.

If you are self-employed or run a small business with your spouse, you may be
eligible for a solo 401(k) plan, also known as an independent 401(k). These
retirement plans allow freelancers and independent contractors to fund their
own retirement, even though they are not employed by another company. A
solo 401(k) can be created through most online brokers.

What Is the Maximum Contribution to a 401(k)?

For most people, the maximum contribution to a 401(k) plan is $20,500 in 2022
and $22,500 in 2023. If you are more than 50 years old, you can make an
additional 2022 catch-up contribution of $6,500 for a total of $27,000 (the
catch-up contribution for 2023 is $7,500 for a total of $30,000). There are also
limitations on the employer's matching contribution: The combined employer-
employee contributions cannot exceed $61,000 in 2022 (or $67,500 for
employees over 50 years old) and $66,000 in 2023 (or $73,500 for employees
over 50 years old).

Is It a Good Idea to Take Early Withdrawals from Your

401(k)?
There are few advantages to taking an early withdrawal from a 401(k) plan. If
you take withdrawals before age 59½, you will face a 10% penalty in addition
to any taxes you owe. However, some employers allow hardship withdrawals
for sudden financial needs, such as medical costs, funeral costs, or buying a
home. This can help you avoid the early withdrawal penalty but you will still
have to pay taxes on the withdrawal.

What Is the Main Benefit of a 401(k)?

A 401(k) plan lets you reduce your tax burden while saving for retirement. Not
only do you get tax-deferred gains but it's also hassle-free since contributions
are automatically subtracted from your paycheck. In addition, many employers
will match part of their employee's 401(k) contributions, effectively giving
them a free boost to their retirement savings.

The Bottom Line

A 401(k) plan is a workplace retirement plan that lets you make annual
contributions up to a certain limit and invest that money for the benefit of your
later years once your working days are done.

401(k) plans come in two types: a traditional or Roth. The traditional 401(k)
involves pre-tax contributions that give you a tax break when you make them
and reduce your taxable income. However, you pay ordinary income tax on
your withdrawals. The Roth 401(k) involves after-tax contributions and no
upfront tax break, but you'll pay no taxes on your withdrawals in retirement.
Both accounts allow employer contributions that can increase your savings.

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