What is a 401(k) and how does it work? 

What is a 401(k)?

A 401(k) is a saving plan that you could be offered by a current or new employer.

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.  

How does a 401(k) work?

You could be offered a 401(k) by your current or new employer.

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 on a 401(k), your pensions administrator should offer you 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), whether your employer will make their own contributions to your plan, and most of all, what type of 401(k) plan you are on.

What different types of 401(k) are there?

While all 401(k) plans are tax-efficient in their own ways, with your contributions almost always being made pre-tax, some 401(k) plans work in a different way 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, that are frequently matched by your employer, but only up to an annual limit. Your money won’t always be vested, or owned by you, until certain conditions are met, so you likely won’t 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) normally used by start-up businesses that don’t have more comprehensive saving plans in place. Only businesses with fewer than 100 employees can use these  

• Roth plans: A Roth 401(k) plan is slightly different to 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 any more when you withdraw this money

• 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 

How much can you contribute to a 401(k) plan?

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.

And while there are ways to maximize each plan for your needs, it’s also important to be aware of the limits of each one, as different plans will only let you invest up to a set amount of money every year, not including any contributions made by your employer. 

Contribution thresholds can change each year, but for traditional, safe harbor and Roth plans, you can contribute an annual maximum of $20,500 of your own income to your plan. If you’re over 50, an additional $6,500 can be added to your yearly limit.  

But with a SIMPLE plan, your maximum contribution is $14,000, as well as an additional $3,000 for over 50s.

With a solo plan, you can contribute as much as $61,000 a year, with a $6,500 add-on for over 50s. 

Withdrawing money from your 401(k)

You can start withdrawing your 401(k) funds without a penalty from the age of 59 ½, and you must withdraw your funds by the age of 72.

If you’re planning to use your 401(k) funds before the normal retirement age, you will need to factor in a range of different taxes and penalties, including federal income tax, a 10 per cent penalty on the amount you withdraw, and any additional state-level taxes.  

Even if you’ve reached retirement age, you may still face some income taxes when your draw your money.

With most 401(k) plans, you’ll contribute to your fund before your income is taxed. But, when you come to use it, you could still be taxed on this money.

However, 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.

Even if you’ve reached retirement age, make sure to take on the right financial expertise to ensure your retirement plans aren’t hit by any unexpected taxes or costs.   

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 with your former employer until you decide to use it.  

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.  

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.  

And 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 three per cent to as much as 10 per cent, so if you’re looking to start building money for the future, a 401(k) is a very good option.  

But this isn’t to say they are the best match for everyone. While pensions work in a similar way to a 401(k), these saving plans are defined-benefit plans, instead of defined-contribution plans.

This means that a pension’s primary aim is to provide a stable income for the future, based on how long you were with a former employer, and how much you earned there.

A 401(k), on the other hand, gives you better flexibility in what financial returns you make, based on the investments and contributions made by you and your employer. 

And for even more flexibility on investing your savings, those more comfortable taking on the investing risk could prefer an IRA, which allows you to invest in riskier and higher-return products, without having your options chosen for you by an employer.