How Does a 401(k) Work? You Need to Understand it for Retirement

Retirement is on every employee's mind, whether they are young or old.

In America, most workers have a 401(k), a similar plan, or a pension. However, fewer and fewer people have access to pensions, so it is essential to know how a 401(k) plan works. Your retired life could depend on it.

A 401(k) plan is a retirement savings plan. It permits employees to save money each pay period. The savings are known as contributions. Depending on the 401(k) type, the contributions are either pre-tax or after-tax. But in both cases, the savings accumulate and ideally grow with time until they are withdrawn from the plan. The money in a 401(k) is invested in whichever mutual funds the worker picks.

Consequently, it is vital to understand how does a 401(k) plan work? Make the wrong choices, and you may not get to retire as early as you desire.

What Is A 401(k)?

A 401(k) plan is a qualified defined contribution plan many employers offer. It allows workers to save for retirement. The plan is named after a section in the United States Internal Revenue Code.

Employees can automatically deduct a percentage of their income from each paycheck into the investment account. In addition, employers may match a part of their employee's contributions, usually up to a limit. Depending on your employer, you may have access to a 401(k), a parallel plan, or both.

Significant changes are occurring for 401(k) plans as passed in the federal government's 2023 spending bill. These changes will adjust the required minimum distribution (RMD) age, increase contribution limits, start automatic enrollment, add a $1,000 hardship withdrawal, etc. Workers should talk to their financial advisors or plan administrator about these changes.

How Does a 401(k) Work in Practice?

For example, suppose you earn $100,000 annually and desire to contribute 6% of your pay to a 401(k). The total amount, $6,000, is divided into the number of pay periods per year, typically 26. The employee contributes roughly $230.77 to the investment account in each paycheck.

The employer may match the employee contribution. For example, if they match 50% up to the first 6%, the amount added to the 401(k) plan would be $115.38 each paycheck. Thus, the combined contribution is $9,000 annually, $3,000 more than the employee's contribution.

Types of Employer-sponsored Retirement Plans

Four types of employer-sponsored retirement plans exist. Most workers have at least heard about the traditional and Roth 401(k) plans. In addition, some workers have access to a 403(b) or a 457(b).

The four types of retirement accounts are conceptually similar because they are all defined contribution plans with comparable contribution levels, investment choices, and withdrawal rules. Some workers may need to pick from two or more types of these plans; thus, it is vital to understand how a 401(k) works.

Traditional 401(k)

Employees contribute pre-tax dollars from their paychecks in a traditional 401(k). The money is invested in funds selected by the employee. Consequently, the taxable income is reduced by the amount contributed. Also, no taxes are paid on the amount contributed until the money is withdrawn, meaning the dollars are tax-deferred.

For instance, if you earned $50,000 and contributed $2,000 into a traditional 401(k), your taxable income is reduced to $48,000. But the $2,000, any investment gains and dividends, are taxed when the money is withdrawn at the prevailing tax rate.

Roth 401(k)

The second type of defined contribution plan is a Roth 401(k) plan. Employees contribute after-tax dollars from their paychecks, so there is no tax deduction. The money is invested in funds selected by the employee.

Since taxes are paid before the contribution is made, they are not paid at withdrawal except on the employer match. Moreover, taxes are not paid on investment gains or dividends, a significant advantage of the Roth 401(k).

403(b)

A 403(b) plan is typically available to workers at a non-profit organization, like public schools, colleges, churches, libraries, hospitals, etc. The plan type is parallel to a 401(k).

Some workers may have access to both a 401(k) and 403(b). However, investment choices may be narrower in a 403(b), and many offer annuities instead of mutual funds, so check with your plan administrator regarding the rules.

457(b)

A 457(b) plan is usually available to civil servants, municipal employees, police officers, firefighters, and executives at hospitals, charities, and unions. This plan type is akin to 401(k) and 403(b), with some differences in maximum contributions. Again, check with your plan administrator regarding the rules.

Contribution Limits

No income limits exist for 401(k) plans. But the IRS enforces a maximum and catch-up contribution limit. These usually increase annually to make up for inflation.

Other rules exist, too, for additional non-deductible after-tax contributions and highly compensated employees. So workers should check their plan rules.

In 2023, the annual maximum contribution is $22,500, and the catch-up limit for those 50 years old and over is $7,500.

In 2022, the annual maximum contribution was $20,500, and the catch-up limit for those aged 50 and over is $6,500.

If an employer offers a Traditional and Roth 401(k), employees can split their contributions between the two. However, they cannot exceed the maximum annual limits.

Employer Match

Another aspect is employer matching. This is money that an employer contributes toward their worker's retirement accounts. Most companies match a percentage of the employee's contribution up to a maximum.

For instance, they may match 50 cents for every dollar the worker contributes up to a specific percentage of salary, like 5% or 6%.

This is not money you see directly as take-home pay. Hence, financial advisors often recommend contributing at least enough of your salary to receive the complete employer match. In effect, this is free money for a retirement investment account.

Vesting

However, most employers have a vesting requirement for their match. If a worker changes jobs and companies before the vesting period ends, the money or a percentage of it goes back to the employer.

For example, suppose the vesting period is three years, and you leave after two years. A possibility is one-third of the employer match is returned while two-thirds stay in your 401(k) plan.

Withdrawals

After retirement, a person can withdraw money without a penalty at age 59-1/2. The funds can then be used for income and living expenses.

The IRS does not allow people to keep money in a 401(k) forever. Depending on their birth year, they must start withdrawing required minimum distributions (RMDs) at either age 70-1/2 or 72.

In 2023, the age requirement for RMD will change to 73. Starting in 2024, the Roth 401(k) will not have an RMD during a worker's lifetime.

How Does a 401(k) Plan Work? What Are the Steps?

Step 1 – Signing Up

When you start a new job, an employer offers a 401(k) or a similar plan as part of your benefits package. At this point, you should learn how a 401(k) plan works.

First, a worker must enroll in the plan, decide how much to contribute annually, and select investment options. This step is crucial for long-term success, but many people don't know how to choose low-cost mutual funds to build a portfolio.

Step 2 – Contribute

Once you receive your paycheck, a portion of it is deposited in an investment account. The funds are allocated to the mutual funds selected by the employee at the specified percentages.

If the money goes towards a Traditional 401(k), it is pre-tax income. If the money goes towards a Roth 401(k), it is after-tax income.

Step 3 – Accumulate and Grow

Money in the 401(k) plan will accumulate and grow with each passing year. Suppose the total contribution is $9,000 annually between the employee and employer match. In five years, the amount saved for retirement is $45,000. But this amount does not account for investment gains and losses.

Over time, investments tend to gain, but annual losses can occur, a risk to future retirees. Moreover, the capital gains and dividends are tax-deferred.

Step 4 – Withdrawal

After you retire, it is time to start withdrawing money from the 401(k) for monthly expenses. The IRS does not allow withdrawals until a person reaches 59-1/2 years old without a penalty.

If the money is withdrawn from a Traditional 401(k), you must pay taxes at your current tax rate. Depending on your birth year, you must take the required minimum distributions by age 70 or 72-1/2.

Bottom Line

While watching their retirement accounts grow, many workers ask themselves, how much should I have in my 401(k)? The answer is, “it depends.”

In the 55 to 64 age bracket, near retirement, the average 401(k) plan balance is $189,800, but the median is much lower at $56,450. This means fewer workers have large balances, pulling the average up. That said, retirees will need a more significant amount combined with Social Security for a secure retirement.

The bottom line is that a young person should start saving for retirement as early as possible. With a longer time horizon, employees can leverage the power of compounding and attain a higher dollar value.

This article was produced by Wealth of Geeks.