401(k)

401(k) summary:

• A 401(k) is a retirement plan that allows employees to make automatic contributions from their paychecks.

• The tax breaks of a 401(k) can result in big savings over time.

• 401(k)s have rules you need to follow to avoid penalties.

401(k) definition and meaning

A 401(k) is a retirement plan some employers offer as a benefit so their employees can make automatic contributions from their paychecks into a tax-advantaged account. Although 401(k)s offer tax breaks, they also have rules you must follow to avoid penalties.

Key concept: A workplace-based retirement plan that allows employees to make automatic, pretax contributions from their paychecks. 

401(k): a comprehensive breakdown

Workplace-based 401(k) plans can have different features, but all have certain features in common.

Automatic contributions

Contributions to your 401(k) are made directly from your paycheck. You decide how much you want to contribute—usually a percentage of your salary, such as 5% or 10%. That sum is automatically deducted from your paychecks, so you don’t have to figure it into your budget. 

Contribution limits

You’re limited in the amount you can contribute to a 401(k) annually, and this limit typically rises by $500 each year. Workers over 50 can make catch-up contributions, usually an additional $7,500 each year. 

The limit on how much you can contribute each year applies cumulatively to all your 401(k) accounts. You can have more than one 401(k) account at different companies. If you have two 401(k)s, you can split your annual contribution between them but you don’t get to contribute twice as much as someone who only has one 401(k) account.

Tax benefits 

With a 401(k), you can either get a tax break on your contributions or your withdrawals, depending on the type of contributions you make. 

Investment choices

Most 401(k) participants expect to be able to invest at least some of their money for optimal growth. Most plans offer a variety of choices. The most typical ones are:

• Target date funds. These funds contain a mix of stocks and bonds, and the asset mix becomes more conservative as you get closer to retirement age. 

• Index funds. These are baskets of investments, typically stocks or bonds, designed to mimic the S&P 500 or the Dow Jones, or another specific index. Since they are passively managed, index funds tend to have very low fees. 

• Mutual funds. A mutual fund contains an assortment of assets, stocks, bonds, and other securities. Since a fund manager chooses the assets and adds or subtracts to achieve good returns, you’ll pay a higher fee for that management. 

• Money market funds. Money market funds are considered quite safe and similar to cash because they are designed to maintain high liquidity and very low risk. They offer easy access to funds with little price change.

Your plan administrator can give you guidance about how to choose the most appropriate investments for the money in your 401(k).

Withdrawal rules

The tax breaks you get with a 401(k) come with withdrawal rules. You'll generally face a 10% early withdrawal penalty for taking a 401(k) distribution before turning 59 1/2 on top of the income tax you’ll pay on whatever you withdraw. 

If you have a traditional 401(k), you'll also have to take required minimum distributions starting at age 73 or later, depending on the year you were born. If you don't take those mandatory distributions, you risk stiff penalties—but you can pay a lower penalty if you make a correction within two years.

Employer matches

Companies that offer 401(k)s often match worker contributions. Employer matching isn't required, and companies can offer whatever match they choose.

Here’s an example of how company matching works. Let’s say your company offers a 401(k) match of up to 3% of your salary and you earn $50,000 a year. If you contribute 3% of your salary—the minimum you’d need to get that match—you’ll put in $1,500 and your employer would also put in $1,500, doubling your contribution. Of course, you can contribute more than 3%, if that’s affordable for you.