What Is a 401(k)? How This Retirement Plan Works

February 01, 2022 · 5 minute read

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What Is a 401(k)? How This Retirement Plan Works

Saving for retirement is one of the smartest investments you can make for your future. Your employer might offer a 401(k) — and maybe matching contributions too — but if you haven’t signed up for a 401(k) before, you might be doubting whether you can afford to take a chunk of money out of your paycheck, especially if you’re just starting out.

In this guide, we’ll break down all things 401(k) — how to get one, how to contribute, and how to make it work for you. We’ll dig into the nitty-gritty of contribution limits, portfolio selection, withdrawal penalties, and more.

What Is a 401(k) Retirement Plan?

A 401(k) is a qualified defined contribution plan that allows employees to contribute some of their wages, tax-deferred, to individual retirement savings accounts. You sign up for the plan through work, and contributions can be deducted directly from your paychecks.

In some instances, employers will match what individual employees contribute, up to a certain amount. Different companies have different vesting schedules for employer contributions, with rules around how long an employee needs to work at the company before they are entitled to employer contributions.

💡 Recommended: Explore other types of retirement accounts.

Where Did The 401(k) Come From?

The 401(k) is named for the section of the Internal Revenue Code that describes it. It was created just after Congress passed the Revenue Act of 1978, which made it possible for employers to start tax-advantaged savings accounts for employees.

The plan grew in popularity quickly, despite hesitation from the federal government, and by 1996 the combined assets of all 401(k) plans topped $1 trillion. Today, it’s the dominant form of retirement savings for American workers.

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

A 401(k) plan comes with many benefits for employees. Here are some of the big ones:

•  Contributions you make to your plan may reduce your taxable income, and that money will not be taxed until it’s distributed at retirement.

•  Because you can set up automatic deductions from your paycheck, you are more likely to save that money, instead of using it for immediate needs.

•  The money is yours. If you change jobs or cannot continue to work, you have the ability to roll over your 401(k) into either your next employer’s 401(k) plan or another retirement account like an IRA.

What are the 401(k) Contribution Limits?

You’ll face two basic limits in contributing to your 401(k) — your personal contributions, and your employer’s. For 2022, the maximum 401(k) contribution is $20,500. If you’re over 50, you can contribute an additional $6,500 as part of a catch-up contribution.

The overall limits on yearly contributions — from both employer and employee — for 2022 are $61,000 ($67,500 with catch-up contributions).

Growing Your 401(k) Investment

While setting up a retirement account is relatively straightforward, making sure it’s invested to match your risk tolerance is a bit more complicated. Your first decision is whether to set up a regular 401(k) or Roth 401(k) account, if your employer offers both options.

The big difference is in how the 401(k)s are taxed. The funds from a traditional 401(k) are taxed when you start to withdraw them in retirement, at the income tax bracket you’re in at that time. A Roth 401(k) is the opposite. You pay income taxes on your contributions before putting them in your Roth 401(k) account. However, when you withdraw your money in retirement, you will not be taxed on it.

As for investing your 401(k) contributions, considerations involve diversifying your funds, how much risk you’re willing to take in the market, and how your 401(k) investments fit into your overall investment portfolio. There are also strategies geared toward maximizing your 401(k), including making sure you take advantage of your employer match.

401(k) Withdrawals and Penalties to Know About

Because a 401(k) plan is a retirement account, there are limitations on withdrawals. When you turn 59 ½ you can begin withdrawing money without penalty, but prior to this, you would pay a fee for withdrawing from your 401(k). If you need to withdraw money from your 401(k) before you reach age 59 ½, you’ll have to pay an additional 10% early withdrawal penalty.

The best way to avoid withdrawal penalties is to keep your money in a 401(k) until you are 59 ½. When you begin to make withdrawals, you can do so either in lump-sum payments or in installments. If you have a traditional 401(k), the money you contribute will be taxed when you withdraw it in retirement. At 72, you’ll be required to start taking money out of your 401(k) — this is known as required minimum distribution — or face fees and penalties.

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How Is a 401(k) Different From Other Retirement Accounts?

Another popular retirement savings account is the IRA. There are traditional and Roth options for IRAs as well. Similar to Roth versus traditional 401(k)s, Roth IRAs involve contributing after-tax income, whereas traditional IRAs tax your money when it’s withdrawn.

While a 401(k) plan must be sponsored by your employer, anyone can open an IRA. Contributions for either type of IRA are limited to $6,000 a year, or $7,000 a year if you’re over 50.

Additionally, Roth IRAs have income restrictions. To qualify for a Roth IRA, an individual must earn below $129,000 (people earning more than $129,000 but less than $144,000 can contribute a reduced amount). For married people who file taxes jointly, the limit is $204,000 to make a full contribution and up to $214,000 for a reduced amount.

The Takeaway

A 40I(k) plan is an employer-sponsored retirement savings plan that allows employees to contribute pre-tax dollars, directly from their paychecks. Plus, in many cases employers will match employee contributions up to a certain amount, meaning your retirement savings will grow faster than if you contributed on your own.

Another step that can help you manage your retirement savings is doing a 401(k) rollover, where you move funds from an old account to a rollover IRA.

SoFi makes the rollover process seamless and simple — no need to watch the mail for your 401(k) check. There are no rollover fees or taxes, and you can complete your 401(k) rollover quickly and easily.

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