How a 401(k) Works

Written by True Tamplin, BSc, CEPF®

Reviewed by Subject Matter Experts

Updated on August 10, 2023

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What Is a 401(k) Plan?

A 401(k) plan is an employee benefit offered by some employers.

Employees may contribute a portion of their income to the plan and in some cases, employers also match contributions.

The money is invested and can be accessed when they retire.

Have questions about 401(k) Plans? Click here.

How Does the 401(k) Work?

A 401(k) plan usually consists of three components: employee deferrals, employer contributions, and investment options.

Under a traditional 401(k), employees choose how much to contribute from their paychecks each month.

Their choices might be limited to a certain percentage of their income.

How much employees contribute is not subject to federal taxes; the employees' paychecks are adjusted accordingly and all contributions go into the 401(k) account.

Employers also make contributions, usually as a percentage of the employees' salaries, but can offer other options such as matching a certain percentage of an employee's contributions up to a certain amount or contributing a flat dollar amount for each pay period in which the employee contributes.

Contributions may consist entirely of pre-tax dollars or part may be made with after-tax dollars.

To invest their money, employees typically choose specific funds within the 401(k) plan, like a target-date fund or a balanced fund.

This way the employee doesn't have to manage this part of their retirement savings and can leave it to a professional financial manager who has access to a wide range of investment choices.

Who Can Contribute to a 401(k)?

Anyone who has a 401(k) plan at their job can contribute.

If an employer offers a match, that contribution is free money, and it's in the worker's best interest to take advantage of that extra savings.

The following conditions apply:

  • You must be employed (working for pay)
  • You must be age 18 or older
  • You must have earned income from working for someone else or as a self-employed individual

If you're married, your spouse can also contribute to a 401(k) even if he/she has another job where there is no employer match.

Similar to taxes on traditional IRA accounts, contributions made to a traditional 401(k) plan are not deductible on a person's federal income tax return.

What Are the Benefits of Having a 401(k)?

401(k) plans have been around since 1978. They have become popular as an alternative to the IRA because they offer several benefits:

  • Contributions made to a 401(k) account are NOT subject to federal taxation until the money is distributed.
  • Employers often match employees' contributions, offering free money towards retirement.
  • Some traditional 401(k) plans allow for variable investments like stocks, bonds, and mutual funds through a professional financial services firm (this may require additional paperwork).
  • You can invest in mutual funds instead of setting up an IRA account at a financial institution where fees may be higher.
  • You can take money out at any time, but if you withdraw before reaching retirement age, there may be penalties for early withdrawal (including taxation).

What Are Some Drawbacks of Having a 401(k)?

  • If you withdraw money from a 401(k) before age 59 1/2, you will be assessed an early withdrawal penalty and your earnings on the withdrawal will be taxed as ordinary income.
  • Employers might use high-commission investments for their plans that may not be in the best interest of employees.
  • Vesting requirements for employees mean some people may not receive the full employer match because they haven't been employed there long enough.
  • High administrative fees can eat into your retirement savings, and some 401(k) plans only offer a limited number of investment options from which to choose.
  • If you're self-employed, you'll need to file a special tax form (5498-MSA) each year that you have a traditional 401(k); you also can't deduct your contributions on your federal income tax return.

How a 401(k) Works FAQs

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon, Nasdaq and Forbes.

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