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How 401(k) Plans Work: Tax Rules, Investments & More

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how does 401k work

As of 2018, around 55 million American workers were active 401(k) participants and assets in 401(k) plans totaled $5.60 trillion. Still, many people are in the dark about how exactly 401(k) plans work and how to maximize their accounts to prepare for retirement. There are a lot of moving parts that you should understand so you can ensure you’re getting the most out of your retirement savings account.

What Is a 401(k) Plan?

A 401(k) is a workplace retirement savings plan, sponsored by a private employer and offered to workers as part of a general benefits package, alongside non-monetary compensation like vacation days and healthcare coverage. While there is no law requiring workplaces to offer a retirement savings plan to employees, many companies do so as a way of attracting top talent.

Companies create 401(k) plans with financial service providers known as recordkeepers. They offer the plan to the company’s employees, who can then choose whether to open an account. Each employee can decide how much money to contribute to their 401(k) each pay period, generally expressed as a percentage of their total paycheck. Employees also choose how to invest that money.

Another benefit some companies offer to employees is an employer match. This means that the company will match a percentage of the money that employees contribute to their 401(k) account. This could be a straight match, which is when a company offers a full match for up to a certain percentage of an employee’s annual income. More commonly it’s a partial match, where a company offers to match half of an employee’s contributions at up to 10% of their paycheck, for instance.

The maximum amount you can contribute to a 401(k) plan in 2019 is $19,000.

Taxes and 401(k) Plans

how does 401k work

Tax treatment is what makes 401(k) plans so attractive to many Americans saving for retirement. Employees contribute money before taxes apply. (There are some plans, called Roth 401(k) plans, where the money is put in after taxes, but these represent a small percentage of 401(k) plans.) You invest the money and withdraw it in retirement. You’ll pay income taxes on the money then, but because most people are in a lower tax bracket in retirement than when they were working they’ll typically pay a lesser amount in taxes. Some states even exempt or partially exempt money withdrawn from retirement accounts from the state income tax.

For now, you won’t need to worry about your 401(k) plan at all when it comes to taxes. The money is taken out of your paycheck before taxes are even applied, so you don’t need to make any deductions or worry about your 401(k) plan when you file your taxes. It also won’t impact your potential refund or increase your overall tax bill.

401(k) Plan Investments

You can choose how to invest your money once you deposit it into the shell of your 401(k) account. You’re able to invest in individual stocks or bonds, purchase a variable annuity or even buy shares in the company you work for, if it is a publicly traded company. All of these options, though, are somewhat risky. For this reason, most 401(k) investors choose to invest in mutual funds and exchange-traded funds (ETFs).

Mutual funds and ETFs take your money and invest it in a number of different securities, including stocks and bonds. The risk is diluted because all of your money is not tied to any single company or security. Mutual funds and ETFs can spread investor money across the entire stock market or focus on a single style or business sector. Actively managed funds have a fund manager who picks stocks in an attempt to beat the market. Passively managed funds track a certain stock index and generally go up and down as the market does.

401(k) Withdrawal Rules

You can’t withdraw money from a 401(k) plan until you turn 59 1/2. Any withdrawals you take before then are subject to ordinary income taxes and a 10% penalty. There are some exceptions, however, including death, disability or a qualified domestic relations order following a divorce.

If you do really need to take money out of your 401(k) before you reach retirement age, you can sometimes take a loan from the plan. You pay back the money over a period of time and the interest rate is low. The biggest risk to this is that if you lose your job and are no longer part of the plan, you must pay back the loan within 60 days. Otherwise, it’s treated as an early withdrawal.

How to Open a 401(k) Plan

how does 401k work

You can’t participate in a 401(k) plan unless you work at a company that offers one. Ask the human resources department if your company offers one. They will also likely have information on enrollment.

Once you receive the relevant information from someone at your company, you can open an account. This will require some basic information, like your Social Security number. Once your account is established, you’ll designate what percentage of each paycheck you want to contribute to your account and where you want to invest the money. You’ll also pick a beneficiary, likely a spouse or another close family member, who will receive your money in the event of your death.

The Bottom Line

A 401(k) plan is a common way to save for retirement. Employers sponsor 401(k) plans and employees invest pre-tax money. Investment options include stocks and bonds, but most people choose to invest in less risky options like mutual funds and ETFs, which are inherently diversified. Some companies may even offer an employer match, giving you free money based on how much you invest.

Retirement Tips
  • A financial advisor can help you figure out how to maximize your 401(k) savings. Find one who meets your needs with SmartAsset’s free financial advisor matching service. You answer a few questions and we match you with up to three financial advisors in your area. All of the advisors are free of disclosures and fully vetted. You make a decision about how you want to proceed after speaking with each advisor match.
  • Don’t forget that you’ll get a Social Security check from the government in addition to your own retirement savings. See how big of a payment you can expect using SmartAsset’s free Social Security calculator.

Photo Credit: iStock/DNY59,  iStock/designer491,  iStock/jygallery

The post How 401(k) Plans Work: Tax Rules, Investments & More appeared first on SmartAsset Blog.

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