What is a 401 (k) and How Does it Work?

Jenny Handwerk |

What is a 401 (k) and How Does it Work? 

Many American firms have 401(k) plans, which are tax-advantaged retirement savings plans. It is named after a section of the United States Internal Revenue Code.

Employees who have a 401(k) plan agree to have a percentage of their pay transferred directly into an investment account. The employer may match a portion or the entire contribution. Usually, the employee can choose from various investment options, most of which are mutual funds.

Each employee is also responsible for selecting investments for their 401(k) from the options supplied by the 401(k) plan provider. However, a default asset allocation is likely to be set up initially. 

The assets you select should be based on your risk tolerance, retirement timeline, and overall investing goals. Target date funds, which are created with your retirement timetable in mind, are becoming more common in plans. They may initially have riskier asset allocations but become more conservative as you approach your retirement date.

How Does It Work? 


The 401(k) has the advantage of automating retirement savings and making investment easier. Your contribution is deducted from your paycheck, your employer's matching contribution is automatically deposited to your account, and depending on the type of 401(k) plan you choose, you may be eligible for some tax benefits.

After depositing monies into the 401(k), the employee can select investment alternatives from the plan's menu. Target-date and other investment funds are frequently available as 401(k) investment options.

The 401(k) then provides additional tax benefits. Once money is contributed to the account and invested, it can grow tax-free for as long as it remains in the account. In other words, a worker will not must pay income or capital gains taxes on earnings in a taxable brokerage account.

Finally, when the employee is ready to retire, they can withdraw funds from their retirement 401(k). Because the contributions were made before taxes, the distributions will be subject to income taxes.


How is a 401(k) different from an IRA?

The fundamental distinction between a 401(k) and an IRA is that a 401(k) is provided by an employer, whereas an individual opens an individual retirement account (IRA) on their own. While IRAs may not give benefits such as employer matching or a more significant contribution limit, they may provide participants more freedom and investment options than a 401(k).

You can contribute to your employment plan and a regular or Roth IRA, depending on your salary.

How much money can I put into my 401(k)?

The IRS determines the amount you are allowed to contribute to a 401(k) yearly. The IRS considers inflation and other market-related factors to establish yearly contribution limitations. The cap for 2023 is $22,500. In 2023, persons 50 and older can make "catch-up" payments of up to $7,500 above the $22,500 cap.

Because annual limitations frequently change, examining them each year is a good idea. If you're already contributing the maximum amount and it rises, you may change your contributions in the new year to increase your savings.


How Does a 401(k) Earn money?


The options provided by your employer invests your contributions to your 401(k) account. As previously stated, these options often include a mix between stock and bond mutual funds and target-date funds designed to decrease the risk of investment losses as you approach retirement.

How much you contribute each year, whether your employer matches your contributions, your investments and their returns, and the number of years you have before retirement all influence how quickly and how much your money grows.

Over a long period, the compounded returns on your 401(k) account may exceed the contributions you have paid to the account. As a result, as you continue to contribute to your 401(k), it can grow into a large sum of money over time.


What occurs if I take an early withdrawal from my 401(k)?

If you withdraw money from your account before age 59 and a half, you must pay taxes on the amount at your marginal federal tax rate, plus a 10% penalty to the IRS. There are, however, several exceptions to the early withdrawal penalty.

The Rule of 55 provides an exception: if you lose (or leave) your job at 55 or older and take distributions from your most recent 401(k), you will not have to pay the 10% penalty. 
Other scenarios that may allow you to escape the 10% penalty (but not the taxes) are as follows:

- Significant medical bills
- Service in the military 

- Permanent incapacity
- A "qualified domestic relations order," such as one obtained as part of a divorce settlement

A corporate retirement plan known as a 401(k) plan enables you to invest money to help you in your later years when you stop working, and you can contribute annually up to a certain amount.

Two types of 401(k) plans are regular and Roth. The classic 401(k) incorporates pre-tax contributions that give you a tax advantage and reduce your taxable income. Your withdrawals, however, are subject to ordinary income tax. The Roth 401(k) requires after-tax contributions and no tax benefit up front, but you will pay no taxes on withdrawals in retirement. Both accounts accept employer contributions, which can boost your savings.