What is a 401(k) and how does it work?
This article breaks everything you need to know about your 401(k), how it works, and what the benefits are.
Summary
A 401(k) is a retirement savings plan typically offered by your current or new employer.
All 401(k) plans are tax-efficient in their own ways.
Each year, the IRS sets contribution limits for 401(k).
A financial advisor can help you develop a retirement plan to meet your needs and goals.
What is a 401(k)?
A 401(k) is a retirement savings plan that a current or new employer could offer you.
Named after a section of the Internal Revenue Service’s (IRS) tax code, a 401(k) is a pot that you can choose to contribute to by setting aside a part of your paycheck.
There’s no obligation to make any minimum payment, but you can only invest a set amount of money into your 401(k) based on the plan type you have and your personal circumstances.
Once you reach retirement age, you can draw on all the money you have saved in your 401(k) to support yourself.
However, 401(k)s do come with some intricacies you should be aware of.
When deciding the best way to save for retirement, it’s always wise to seek expert financial advice. A qualified financial advisor can help you develop a retirement plan to meet your needs and goals.
You can find a financial advisor with Unbiased. Answer a few simple questions, and we’ll find your perfect match. Get started here.
How does a 401(k) work?
Your current or new employer could offer you a 401(k).
The money that you deposit in your 401(k) account is invested into a range of different funds that generate better returns for you the longer they are invested.
So, when you enroll in a 401(k), you should be offered a range of different plans that you can invest in, each of which will generate different returns.
But as with any investment, the exact amount of money you get back will vary depending on the amount of money that you move into your 401(k) and what type of 401(k) plan you are on.
It’s also worth noting that many employers, not all, will match contributions you make to your 401(k) plan.
Commonly known as 401(k) matching, your employer will contribute up to a certain amount to your retirement savings plan each month. This is essentially free money for your future and grows with your own contributed money.
What different types of 401(k) are there?
All 401(k) plans are tax-efficient in their own ways, with your contributions almost always being made pre-tax.
However, some 401(k) plans work differently and might be a better option for you.
The five most common types of 401(k) plans are:
Traditional plans: A traditional 401(k) lets you make pre-tax contributions to your plan. Your employer frequently matches these but are only up to an annual limit. Your money won’t always be vested – owned by you – until certain conditions are met, so you’ll unlikely be able to draw on your money until you’ve been a part of your current business for a set amount of time.
Safe harbor plans: A safe harbor plan works in largely the same way as a traditional plan, except that employer contributions are always vested, so you’ll have much more ownership of the money in your 401(k).
SIMPLE plans: The Savings Incentive Match Plan for Employees (SIMPLE) is a 401(k) plan normally used by start-up businesses that don’t have more comprehensive saving plans in place. Only companies with fewer than 100 employees can use these.
Roth plans: A Roth 401(k) plan is slightly different from other plans in that it uses post-tax income to make contributions. In the eyes of the tax authorities, this money has already been taxed, so you won’t be taxed when you withdraw this money as long as certain conditions are met, for example, you are over the age of 59 ½.
Solo plans: A solo plan is for businesses with only one employee, meaning that even if you’re self-employed, you can save for your future based on your business’ income
Depending on the kind of business you work for and your employer’s preferences, you could be offered any of the above 401(k) plans.
How much can you contribute to a 401(k) plan?
Different plans will only let you invest up to a set amount of money every year, not including any contributions made by your employer. While there are ways to maximize each plan for your needs, it’s also important to be aware of the limits of each one.
Contribution limits change each year.
Many plans also allow for catch-up contributions, which are additional payments those over the age of 50 can make to their plan.
Here is a breakdown of the different contribution limits for each plan for 2024:
| Contribution limit | Catch-up contribution limit | Employee & employer contribution limit | |
|---|---|---|---|
| 401(k) | $23,000 | $7,500 | $69,000 |
| SIMPLE 401(k) | $16,000 | $3,500 | Employers can match dollar-for-dollar up to 3% of pay |
| Solo 401(k) | $69,000 | $7,500 |
Here is a breakdown of the different contribution limits for each plan for 2023:
| Contribution limit | Catch-up contribution limit | Employee & employer contribution limit | |
|---|---|---|---|
| Traditional & Roth 401(k) | $22,500 | $7,500 | $66,000 |
| SIMPLE 401(k) | $15,500 | $3,500 | Employers can match dollar-for-dollar up to 3% of pay |
| Solo 401(k) | $66,000 | $7,500 |
When do I start withdrawing money from my 401(k)?
You can start withdrawing your 401(k) funds without a penalty from the age of 59 ½.
If you withdraw money from your 401(k) early, before this age, you may encounter a 10% penalty charge. This is on top of federal and state taxes.
The IRS also imposes restrictions on how long you can leave your money in your 401(k). You must withdraw your funds by the age of 72.
How much tax will I pay on my 401(k) withdrawals?
Depending on your 401(k) type, you may still face some income taxes when you draw your money.
With most 401(k) plans, you’ll contribute to your fund before your income is taxed. This means you will pay income tax on the money when you withdraw it. This tax will be at your current income tax rate.
With a Roth plan, your funds will have already been taxed, meaning that you will be able to draw on your funds without additional taxes.
What happens to your 401(k) if you leave your job?
Your 401(k) is tied to your employer and the 401(k) plans that they have selected for their employees.
So, if you leave your current role, you won’t be able to continue contributing to that specific plan. But this doesn’t mean that you can’t access your money again.
If your new employer offers 401(k) plans, you can roll your existing funds into a new plan.
Or, if you already have a substantial amount saved in your former plan, it could be a good idea to leave your funds where they are until you decide to use them.
You also have the option of rolling your 401(k) funds into an individual retirement account (IRA).
IRA accounts work in largely the same way as a 401(k), but instead of having your funds invested in one of a number of plans already selected by your employer, you’ll be investing your retirement funds in the way that suits your needs best.
This process can be complex and could require you to pay some tax depending on your retirement plan type.
If you’re considering rolling over your 401(k), it’s best to get expert financial advice. Unbiased can match you with a regulated financial advisor in as little as 48 hours who can help you with all of your financial queries.
Is a 401(k) right for me?
Any opportunity to save money for your future should be taken seriously.
Unlike saving options that require you to take a hands-on approach or require a lot of planning, having a 401(k) is an easy and flexible way to start building up your savings, however slowly or quickly you want to do it.
Also, when it comes to generating returns, a 401(k) can be an extremely good option, depending on the investment plans presented to you.
The average returns for a 401(k) can be anywhere from 3% to as much as 10%, so if you’re looking to start building money for the future, a 401(k) is a very good option.
Get expert retirement advice
Planning for retirement can be a complex and daunting process. With so many different retirement savings accounts to choose from, it can be difficult to understand which is the best option for you.
This is where financial advice becomes invaluable.
A financial advisor can help you build a comprehensive and personalized plan that will help you reach your retirement goals.
Finding a financial advisor doesn’t have to be difficult. At Unbiased, we can connect you to a financial advisor perfectly suited to meet your needs in as little as 48 hours.
Just answer a few simple questions, and we’ll look after the rest.
Rana is the Chief People Officer at Unbiased.com.
Rana is the Chief People Officer at Unbiased.com. She has over 20 years of experience as a commercial HR leader supporting start-ups and scale-ups with their Talent & People Strategy to ensure growth, with experience across eCommerce, Hospitalitytech, and Fintech sectors.