401(k) Plan : How It Works & Limits

What Is a 401(k) Plan?

A 401(k) plan is a retirement savings plan offered by many American employers that has tax advantages to the saver. It is named after a section of the U.S. Internal Revenue Code.

The employee who signs up for a 401(k) agrees to have a percentage of each paycheck paid directly into an investment account. The employer may match part or all of that contribution. The employee gets to choose among a number of investment options, usually mutual funds.

How 401(k) Plans Work

The 401(k) plan was designed by Congress to encourage Americans to save for retirement. Among the benefits they offer is tax savings.

There are two main options, each with distinct tax advantages:

Not all employers offer the option of a Roth account.

If the Roth is offered, the employee can pick one or the other or a mix of both, up to annual limits on their tax-deductible contributions.

Contributing to a 401(k) Plan

A 401(k) is a defined contribution plan. The employee and employer can make contributions to the account up to the dollar limits set by the Internal Revenue Service (IRS).

A defined contribution plan is an alternative to the traditional pension, which is known in IRS lingo as a defined-benefit plan. That is, an employer who offers a pension is committed to providing a specific amount of money to the employee for life during retirement.

In recent decades, 401(k) plans have become more common, and traditional pensions have become rare as employers shifted the responsibility and risk of saving for retirement to their employees.

Employees also are responsible for choosing the specific investments within their 401(k) accounts, from a selection their employer offers. Those offerings typically include an assortment of stock and bond mutual funds as well as target-date funds that are designed to reduce the risk of investment losses as the employee approaches retirement.

They may also include guaranteed investment contracts (GICs) issued by insurance companies and sometimes the employer's own stock.

Contribution Limits

The maximum amount that an employee or employer can contribute to a 401(k) plan is adjusted periodically to account for inflation.

As of 2020 and in 2021, the limits on employee contributions are $19,500 per year for workers under age 50 and $26,000 for those 50 and up (including a $6,500 catch-up contribution).

If the employer also contributes, or if the employee elects to make additional, non-deductible after-tax contributions to their traditional 401(k) account, the total employee/employer contribution for workers under 50 for 2021 is capped at $58,000, or 100% of employee compensation, whichever is lower. For those 50 and over, again for 2021, the limit is $64,500.

Employer Matching

Employers who match their employee contributions use various formulas to calculate that match.

For instance, an employer might match 50 cents for every dollar the employee contributes up to a certain percentage of salary.

Financial advisors often recommend that employees contribute at least enough money to their 401(k) plans each to get the full employer match.

Contributing to Both a Traditional and Roth 401(k)

If their employer offers both types of 401(k) plans, employees can split their contributions, putting some money into a traditional 401(k) and some into a Roth 401(k).

However, their total contribution to the two types of accounts can't exceed the limit for one account (such as $19,500 for those under age 50 in 2020 and 2021).

Employer contributions can only go into a traditional 401(k) account where they will be subject to tax upon withdrawal, not into a Roth.

Taking Withdrawals from a 401(k)

Once money goes into a 401(k), it is difficult to withdraw it without paying a tax penalty.

"Make sure that you still save enough on the outside for emergencies and expenses you may have before retirement," says Dan Stewart, CFA®, president of Revere Asset Management Inc., in Dallas. "Do not put all of your savings into your 401(k) where you cannot easily access it, if necessary."

The earnings in a 401(k) account are tax-deferred in the case of traditional 401(k)s and tax-free in the case of Roths. When the owner of a traditional 401(k) makes withdrawals, that money (which has never been taxed) will be taxed as ordinary income. Roth account owners have already paid income tax on the money they contributed to the plan and will owe no tax on their withdrawals, as long as they satisfy certain requirements.

Both traditional and Roth 401(k) owners must be at least age 59½ — or meet other criteria spelled out by the IRS, such as being totally and permanently disabled — when they start to make withdrawals.

Otherwise, they usually will face an additional 10% early-distribution penalty tax on top of any other tax they owe.

Some employers allow employees to take out a loan against the money they have contributed to a 401(k) plan. Basically, they're borrowing from themselves. If you consider this option, keep in mind that if you leave the job before the money is repaid, you'll have to repay it in a lump sum or face the 10% penalty for an early withdrawal.

Required Minimum Distributions

Traditional 401(k) account holders are subject to required minimum distributions, or RMDs, after reaching a certain age. (Withdrawals are often referred to as "distributions" in IRS parlance.)

After age 72, account owners who have retired must withdraw at least a specified percentage from their 401(k) plans, using IRS tables based on their life expectancy at the time. (Prior to 2020, the RMD age was 70½ years old.)

People who are still working may not have to take RMDs.

Note that distributions from a traditional 401(k) are taxable. Qualified withdrawals from a Roth 401(k) are not.

Roth IRAs, unlike Roth 401(k)s, are not subject to RMDs during the owner's lifetime.

Traditional 401(k) vs. Roth 401(k)

When 401(k) plans first became available in 1978, companies and their employees had just one choice: the traditional 401(k). Then, in 2006, Roth 401(k)s arrived. Roths are named for former U.S. Senator William Roth of Delaware, the primary sponsor of the 1997 legislation that made the Roth IRA possible.

While Roth 401(k)s were a little slow to catch on, many employers now offer them. So the first decision employees often have to make is between Roth and traditional.

As a general rule, employees who expect to be in a lower marginal tax bracket after they retire might want to opt for a traditional 401(k) and take advantage of the immediate tax break.

On the other hand, employees who expect to be in a higher bracket after retiring might opt for the Roth so that they can avoid taxes on their savings later. Also important — especially if the Roth has years to grow — is that there is no tax on withdrawals, which means that all the money the contributions earn over decades of being in the account is tax-free.

As a practical matter, the Roth reduces your immediate spending power more than a traditional 401(k) plan. That matters if your budget is tight.

Since no one can predict what tax rates will be decades from now, neither type of 401(k) is a sure thing. For that reason many financial advisors suggest that people hedge their bets, putting some of their money into each.

Special Considerations: When You Leave Your Job

When an employee leaves a company where they have a 401(k) plan, they generally have four options:

1. Withdraw the Money

This is a bad idea unless the employee urgently needs the cash. The money will be taxable in the year it's withdrawn, and the employee will be hit with the additional 10% early distribution tax unless they are over 59½, permanently disabled, or meet the other IRS criteria for an exception to the rule.

This rule has been suspended for 2020 for those affected by the 2020 COVID-19 economic crisis.

In the case of Roth IRAs, the employee's contributions (but not any profits) may be withdrawn tax-free and without penalty at any time as long as the employee has had the account for at least five years. Remember, they're still diminishing their retirement savings, which they may regret later.

2. Roll Your 401(k) into an IRA

By moving the money into an IRA at a brokerage firm, a mutual fund company, or a bank, the employee can avoid immediate taxes and maintain the account's tax-advantaged status. What's more, the employee will be able to choose among a wider range of investment choices than with their employer's plan.

The IRS has relatively strict rules on rollovers and how they need to be accomplished, and running afoul of them is costly. Typically, the financial institution that is in line to receive the money will be more than happy to help with the process and avoid any missteps.

Funds withdrawn from your 401(k) must be rolled over to another retirement account within 60 days to avoid taxes and penalties.

3. Leave Your 401(k) with the Old Employer

In many cases, employers will permit a departing employee to keep a 401(k) account in their old plan indefinitely, although the employee can't make any further contributions to it. This generally applies to accounts worth at least $5,000. In the case of smaller accounts, the employer may give the employee no choice but to move the money elsewhere.

Leaving 401(k) money where it is can make sense if the old employer's plan is well managed, and the employee is satisfied with the investment choices it offers. The danger is that employees who change jobs over the course of their careers can leave a trail of old 401(k) plans and may forget about one or more of them. Their heirs might also be unaware of the existence of the accounts.

4. Move Your 401(k) to a New Employer

You can usually move your 401(k) balance to your new employer's plan. As with an IRA rollover, this maintains the account's tax-deferred status and avoids immediate taxes.

It could be a wise move if the employee isn't comfortable with making the investment decisions involved in managing a rollover IRA and would rather leave some of that work to the new plan's administrator.

In addition, if the employee is nearing age 72, note that money in a 401(k) at one's current employer may not be subject to RMDs. Moving the money will protect more retirement assets under that umbrella.

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

A 401(k) Plan is a retirement savings vehicle that allows employees to have a portion of each paycheck directly paid into a long-term investment account. The employer may contribute some money as well.

There are immediate tax advantages for the employee if the account is a traditional 401(k), and tax advantages after retiring if it is a Roth 401(k).

In either case, the money earned in the account will not be taxed until it is withdrawn during retirement if it is a traditional 401(k). If it is a Roth 401(k), no taxes will be due when the money is withdrawn.

Is It Worth Having a 401(k) Plan?

Generally speaking, 401(k) plans are a great way for employees to save for retirement. They make it easy to save because the money is automatically deducted. They have tax advantages for the saver. And, some employers match the contributions made by the employees.

All else being equal, employees have more to gain from participating in a 401(k) plan if their employer offers a contribution match.

How Much of My Salary Can I Contribute to a 401(k) Plan?

The amount that employees can contribute to their 401(k) Plan is adjusted each year to keep pace with inflation. In 2020 and 2021, the limit is $19,500 per year for workers under age 50 and $26,000 for those aged 50 and above.

If the employee also benefits from matching contributions from their employer, then the combined contribution from both the employee and the employer is capped at the lesser of $58,000 or 100% of the employee’s compensation for the year.