What Is a 401(k)?

What Is a 401(k)? article image.

A 401(k) is a retirement savings account offered by employers as part of their employee benefits programs. Designed to encourage employees to save for retirement, 401(k) plans offer incentives including income tax reductions and matching contributions, where the employer agrees to contribute additional funds to the employee's account. All these benefits—plus the ease of having funds directly deposited into the account—make 401(k) plans an excellent way to save for retirement.

How Does a 401(k) Plan Work?

At some businesses, enrollment in the company's 401(k) plan is an automatic part of the hiring process; at other workplaces, 401(k) eligibility kicks in after a few months' probationary period. Either way, you're free to decline if you don't wish to participate—but there are many more reasons to sign up than there are to opt out.

When you enroll in your employer's 401(k) plan, you'll need to specify how much you want to save (as a percentage of your paycheck). You'll also have a choice of investment funds into which you can place your savings. If multiple investment funds are available, your HR rep will supply you with background on all of them: Some are typically more aggressive investment vehicles than others, seeking higher returns but with relatively greater risk of loss, while others are more conservative. Different employers offer different numbers and types of funds. You can put all of your funds in any one of them, divide your savings evenly across all of the accounts, or otherwise pick and choose your allocations among all the funds.

Your company will take whatever amount you choose out of your pay automatically and deposit it in the 401(k) investment fund before you ever see your paycheck or direct deposit. This makes it one of the easiest ways to save for retirement.

Even better, contributions to your 401(k) funds are considered pretax income: You are exempt from paying income tax on them until you withdraw them from your 401(k) fund in your retirement—when you are age 59 1/2 or older. This serves as a double tax incentive: It reduces the amount of tax you pay during your peak earning years, when your income is greatest and your tax bracket—the rate at which your income is taxed—is proportionately highest. When you begin withdrawing from your 401(k) in retirement (and you must begin withdrawing funds when you reach age 70 1/2), your 401(k) proceeds are taxable as income. But because your income and tax bracket in retirement likely will be substantially lower than they were during your working years, you'll pay proportionately less tax on those funds.

Another incentive for saving with a 401(k) is the employer contribution match. Many, but not all, plans offer this, and each company that provides a match has its own formula for doing so. One common scheme is to make a 50% matching contribution on up to 6% of your salary. That means if you save up to 6% of your salary in your 401(k) account, your employer will add 50 cents for every dollar you save, which works out to another 3% in your account. (You can save more than 6% if you choose, but in this example, your employer wouldn't match anything beyond that first 6%.) All money you contribute to your 401(k) is yours forever. Your employer match, however, may take several years to "vest," or become 100% yours.

What if My Employer Doesn't Offer a 401(k)?

Not every employer offers a 401(k) plan, but you can get at least some of the benefits of one by opening an Individual Retirement Account (IRA) through a bank or discount brokerage. There are two different types of IRAs, each with distinct tax implications and advantages:

  • A traditional IRA offers tax benefits similar to a 401(k), by letting you save money on a pretax basis. You pay no income tax on contributions to a traditional IRA until you withdraw them during retirement. As of 2019, you can save up to $6,000 annually in a traditional IRA if you're age 50 or under; if you're over 50 (and younger than 70 1/2, the age at which you must begin withdrawing funds from a traditional IRA), you can save up to $7,000 annually.
  • A Roth IRA handles your savings differently. Roth IRA contributions are post-tax funds: You pay taxes on them now. Your contributions don't reduce your current tax liability, but when you withdraw the funds, as long as you've had your Roth IRA for at least five years, the proceeds won't count as taxable income. If the amount in the fund has grown, that can mean major income tax savings. Contribution limits on Roth IRAs are the same as on traditional IRAs: $6,000 annually if you're 50 or under, and $7,000 if you're over 50. You can contribute to a Roth IRA no matter how old you are, and there's no mandatory age at which you must start withdrawing funds from one. There is, however, an income limit on participation in a Roth IRA: If you are single and earn more than $137,000 or married filing jointly and earn more than $203,000 in 2019, you are ineligible to contribute to a Roth IRA.

Traditional and Roth IRAs can take the place of 401(k) funds for individuals without access to 401(k) plans through work, and in some cases they also can be useful as supplements to 401(k) plans, particularly for high earners who have maxed out their 401(k) contributions and want to set aside additional savings for retirement.

How Much Should I Be Contributing to My 401(k)?

In 2019, employees under 50 years old are allowed to save up to $19,000 each year in a 401(k). Older workers are eligible for a catch-up contribution that pushes their annual limit to $25,000. Those limits are adjusted periodically to keep pace with inflation.

Exactly how much you contribute may vary, but you should try to be strategic about getting as much from your 401(k) program as you can. If you can afford to fully fund your 401(k) every year, that's great, but don't worry if you can't. Try to sock away 10% to 15% of your income if you can, but at the very least aim to contribute the maximum amount your employer will match each year. If you leave matching funds untapped, you're forfeiting a significant portion of your compensation package.

What Happens to My 401(k) if I Leave My Job?

If you leave your job, all of your 401(k) contributions, plus whatever portion of your employer match is vested, is yours to keep. You may have the option of leaving it in the care of the plan administrator, where your investments will stay allocated as they were, but often when you cease to be an employee, administrative fees on your investments (which employers help cover as an employee perk) tend to increase, reducing any effective yield on the investments.

A better option, then, is to roll over the funds in your old 401(k) plan into the 401(k) plan you have with a new employer. If you're not moving into a job with a 401(k) program, you also can roll the old 401(k) holdings into a traditional or Roth IRA account without penalty.

Can I Withdraw From My 401(k)?

Taking money out of your 401(k) fund before you reach the age of 59 1/2 can have significant drawbacks. In the event of an early withdrawal, you'll pay a 10% penalty on the amount you take out, and the withdrawal amount will be fully taxable as income.

There also are provisions for giving yourself a loan of up to $50,000 from your 401(k). The consequences of borrowing from yourself are less dire than making an outright withdrawal, but a 401(k) loan is typically very disruptive to the retirement savings process. Repaying a 401(k) loan typically interferes with contributions to the retirement fund: It's often difficult to make loan repayments (which include interest charges—albeit ones you're paying yourself) while maintaining retirement savings contributions in the same amount you paid in before you started making loan payments.

Will Withdrawing From My 401(k) Impact My Credit?

Withdrawals from your 401(k) plan—whether they're made early (before you turn 59 1/2) and incur penalties, or are taken after age 59 1/2 as part of your retirement income—have no direct bearing on your credit report or credit score. That's because the national credit bureaus (Experian, Equifax and TransUnion) do not track 401(k) activity or income from your 401(k) or any other source.

Taking out a loan from a 401(k) plan or, under extreme adverse conditions, making an early 401(k) withdrawal could indirectly benefit your credit standing if you use the proceeds to pay down outstanding debt or to avoid defaulting on a loan or credit card account. If you feel compelled to make an early 401(k) withdrawal to deal with outstanding debt, it would be wise to consult a financial advisor or certified credit counselor to make sure you fully understand the related penalties and tax consequences of doing so.

Note that, unlike payments on a personal loan, payments on a 401(k) loan do nothing to benefit your credit standing, since 401(k) loan payments are not reported to or tracked by the three national credit bureaus.

A 401(k) plan is an excellent vehicle for retirement savings, and a great employment benefit. If you're in a position to take advantage of one, take advantage of it as fully as you can afford to.