What Is a 401(k) Plan and How Does It Work?

A 401(k) plan is a retirement plan sponsored by employers in the U.S. It is a retirement account where employees contribute a percentage of their income from their paychecks. Oftentimes, this percentage is matched by employers. 

But what is a 401(k) plan, really? How does it work? In this comprehensive guide, we will find out what a 401(k) retirement plan is, how it works, and how much you can contribute to it. So read on to make informed financial decisions for your retirement planning.

What Is a 401(k) Plan?

401(k), named after its tax code section, is a retirement savings plan in the U.S. sponsored by employers. It is a part of the employer’s benefits package designed to retain employees.

However, not every employer offers a 401(k) plan. If you’re self-employed, you can also open up a self-employed 401(k) account to save for retirement.

Types of 401(k) Plans

There are two types of 401(k) plans, traditional 401(k) and Roth 401(k). The main difference between these two is their tax benefits. Read on to learn about these differences in detail:

1. Traditional 401(k)

In a traditional 401(k) plan, the employees make contributions from their paychecks before the IRS taxes are applied. Therefore, your retirement savings are free from taxation. 

You will not be required to pay any taxes as long as the retirement funds are in your account. As a result, your total taxable income for the year also decreases. However, when you withdraw money from the retirement account, you will have to pay income taxes to the IRS. 

What’s more, once you reach a certain age, you will have to take a required minimum distribution (RMD), which is the money you need to withdraw from your tax-deferred retirement account as per IRS’s requirements. This is not required in a Roth 401(k) plan.

2. Roth 401(k)

A Roth 401(k) plan allows you to contribute your after-tax income toward your retirement savings. And when you make withdrawals from your Roth 401(k) retirement account, you won’t be required to pay any taxes.

Just like a traditional 401(k), a Roth 401(k) keeps you from paying taxes as long as your money is in the account. No matter how much your investment grows, you won’t owe anything to the IRS. 

But unlike the traditional 401(k), you don’t owe any taxes to the IRS when you take out qualified distributions from a Roth 401(k) account. However, this only applies when you have maintained the account for 5 or more years and are at least 59 and a half years old. 

This is because you have already paid any taxes due as you contributed your after-tax income. Moreover, any income you get from this account grows tax-free. So you won’t owe anything to the IRS by the time you withdraw your money.

How Does a 401(k) Plan Work?

Most companies automatically enroll employees into a 401(k) plan. When you open a 401(k) retirement investment account, you are signing up for a percentage of your paycheck to be automatically transferred to your 401(k) account. 

If your employer matches your contributions, the sum of both of your contributions is invested in a variety of investments. As the investment grows, it remains saved and tax-deferred until you withdraw it. 

401(k) Plan Frequently Asked Questions (FAQs)

Q1: How much can I contribute to my 401(k)?

Employees can contribute up to $23,000 of their income to their 401(k) plans in 2024. This figure increases to $30,500 for people aged 50 or more. 

Q2: Where does 401K money go?

The money you contribute to your 401(k) plan goes into various investments offered by your employer’s provider. These can range from target-date funds and bond mutual funds to a selection of stock.

Q3: What are the 401(k) withdrawal rules?

To withdraw your money from a 401(k) account, you are required to be at least 59 and a half years old, be eligible for a hardship withdrawal, or have a qualifying disability. 

If you do not meet any of these requirements, then you will have to pay a 10% early withdrawal penalty. What’s more, you will have to count your withdrawal in your income when filing taxes. 

However, if you need to cover any emergency expenses, you can withdraw up to $1,000 without paying any penalties. The withdrawn amount should be repaid within three years. 

 Q4: What happens to my 401(k) if I quit my job?

If you quit your job, you will get all the money in your 401(k) account. You can either roll the amount into an IRA or into a new 401(k) plan. These transfers are not taxable if done within 60 days.