Takeaways
- 401(k) plans are tax-advantaged employer-sponsored retirement accounts.
- 401(k) plans have two basic types: Traditional 401(k)s and Roth 401(k)s.
- Employer contributions are free funds to boost retirement savings tremendously.
- Employee contributions to a Traditional 401(k) account reduce taxable income.
- Defined contribution plans like a 401(k) plan are the most common workplace retirement plan.
Picture your dream retirement. You are probably traveling the world, enjoying your hobbies, and relaxing, but have you ever thought about how you are going to fund your retirement? Believe it or not, it is possible to live a life of comfort and leisure after you stop working and earning a regular income. And one of the most utilized retirement saving methods, the employer-sponsored 401(k) plan, can help you get there quickly
What is a 401(k) Plan?
401(k) plans are defined contribution plans where employees contribute funds from their paycheck into an account. Employers can then place matching contributions into the employee’s account to boost savings. Once the funds are in the employee 401(k) account, the employee can invest the funds into different investment securities, such as mutual funds, target date funds, and exchange-traded funds to save for retirement.
Over the past several decades, there has been a major shift in the U.S. from companies providing defined pension programs to defined contribution programs. This change has led to significant 401(k) savings over time. A 2023 report by The Vanguard Group, an investment advisory firm, found that the average 401(k) balance is $112,5721.
Smart Money -> Need More Money? Try These 29 Side Hustle Ideas
You can save for your retirement throughout your career by contributing to your 401(k) plan while enjoying tremendous tax benefits. However, it is vital to plan for your retirement savings because the IRS caps how much you can contribute to your 401(k) account in a year ($22,500 for those below 50 and $30,000 for those above 50). With matching contributions from your employer, your retirement savings can balloon over time.
Employees can access their investments in the account before or after retirement. However, the IRS has specific criteria for accessing funds before your retirement and rules for how withdrawals must take place.
Smart Money -> What is Investment Risk Tolerance?
How Does a 401(k) Work?
401(k) plans are named after Section 401 of the U.S. Internal Revenue Code, which governs retirement savings. 401(k) plans were first introduced in 1978 by Congress to encourage Americans to save more for retirement. The chief appeal of participating in a 401(k) plan is receiving tax advantages.
A 401(k) plan involves contributing a portion of your paycheck toward an investment account. Your employer can make matching contributions to your account, which can vary in size and vesting. The idea is for you and your employer to be invested in your success.
Smart Money -> What is Discretionary Income?
After you retire, you can withdraw funds from your 401(k) account. By that time, hopefully, your retirement account will consist of contributions from you and your employer as well as investment gains that have compounded over time to increase your savings balance.
What happens when you move from one employer to another? You can transfer your 401(k) balance from one employer's 401(k) plan provider to another and consolidate your savings into a single account. Moving all your retirement savings into one account makes managing your retirement accounts easy.
Smart Money -> What is an Investment Time Horizon?
Two Types of 401(k) Plans
Today, employers offer employees two main types of 401(k) plans: Traditional 401(k) and Roth 401(k). There are a variety of features, which separate these two types of 401(k) accounts. Here are the critical differences:
1. Traditional 401(k)
A traditional 401(k) plan takes employee contributions from your gross income before taxes. Because of this, every contribution to your 401(k) reduces your taxable income. This tax treatment is a huge incentive to start your 401(k)-retirement savings account because it increases your savings power.
Here is an example: let’s say you make $100,000 a year and put $20,000 of employee contributions into your 401(k) account throughout the year. Instead of paying income tax on your total income of $100,000, you now only pay income taxes on $80,000 ($100,000 - $20,000). In this scenario, you protect $20,000 of income from being taxed by Uncle Sam. If you pay 24% income taxes, you would save yourself from paying $4,800 in income taxes ($20,000 X 24%).
Once the income you have contributed to your 401(k) is in your account, you do not pay taxes on that payment. Additionally – and this is important – you do not pay capital gains taxes on investment growth once the funds are in your 401(k). As a result, you don’t pay taxes on stock investment gains, dividend income, or interest income.
You will only be taxed on withdrawals you make during retirement. How much you are taxed will depend on your tax bracket at the age of retirement.
Smart Money -> What is a Traditional IRA?
2. Roth 401(k)
A Roth 401(k) plan takes employee contributions from your paycheck after income taxes. The critical difference between a Traditional 401(k) and a Roth 401(k) is that with a Roth 401(k), your withdrawals will be tax-free. Tax-free withdrawals are a huge incentive to start your 401(k)-retirement savings account because they increase your savings power.
Smart Money -> What is a Roth IRA?
With a Roth 401(k), your investments are allowed to grow tax-free. That means, just like a Traditional 401(k), you don’t pay taxes on stock investment gains, dividend income, or interest income. Once you retire, you don’t pay taxes when you withdraw any of these investments. Because you paid income taxes on these funds before they were contributed, they are allowed to grow tax-free, and there are no taxes upon withdrawal.
Smart Money -> What is the Stock Market?
Hardship Withdrawal
In 2024, the IRS changed the withdrawal rules to allow for a hardship withdrawal of up to $1,000 for emergency expenses. However, we recommend saving an emergency fund and slush fund, so that you avoid having to take a hardship withdrawal from your retirement accounts altogether. You will increase your net worth and financial health by letting your retirement accounts grow unencumbered.
Smart Money -> 5 Amazing Smart Money Savings Habits to Start Now
401(k) Plans: Pros and Cons
While a 401(k) plan can be an effective way to save for retirement, you should research the advantages and disadvantages before participating in any workplace retirement program.
Advantages of a 401(k)
Taxes: Both Traditional 401(k)s and Roth 401(k)s allow employees to save money on taxes. If you select to participate in a Traditional 401(k) you contribute pre-taxed income to your account, which means they are not taxed. You are only taxed on your 401(k) investments once you withdraw the funds during retirement. However, with a Roth 401(k), you contributed after-tax dollars to the account. Because you contribute previously taxed money, your Roth 401(k) investments grow tax-free.
Matching Contributions: Employers typically match a percentage of the funds you decide to put into your account. For example, if you contribute $10,000, your employer might add $4,000 in matching contributions. This $4,000 employer matching contribution is free money that you can keep.
Access to Funds: Your 401(k) also acts as a pool of capital you can access in times of need. If you need a loan, you can take out a loan against the savings in your 401(k) plan. 401(k) loans have limits. The IRS allows you to take out a loan up to 50% of your vested 401(k) retirement savings with a $50,000 loan limit.
Disadvantages of a 401(k)
Investment Fees: Like with any investment account, there are fees associated with your employer’s plan provider. There are three fee categories: plan administration, investment, and individual service fees2. Employers often try to negotiate the lowest fee structure possible for their employees.
Contribution Limits: Total employee contributions to 401(k) plans are limited by the IRS. For the tax year 2023, the total contribution limit for employees who participate in 401(k) plans is $22,500. If you are 50 years old (or older), you are allowed a catch-up contribution limit of $7,5003.
Early Withdrawal Penalty: Once you start contributing to your 401(k), it can be difficult to withdraw funds from your account without paying fees and penalties. Early withdrawals (withdrawals made before you are 59 and a half years old) are subject to a penalty of 10%. However, some exclusions apply. These fees incentivize you to keep your funds in your retirement account and let them grow until you need them for retirement.
Limited Investment Options: The investment options for a 401(k) plan are much more limited than if you were to invest from an individual online brokerage account. 401(k)s plans offer a curated list of pre-selected investments by your employer’s plan provider. Typically, your plan includes mutual funds, target date funds, and exchange-traded funds.
Mandatory Withdraws: 401(k) plans are designed to incentivize saving for retirement. However, once you retire, the rules are structured to encourage you to use the funds. In fact, after you are 72 years old, you must make minimum withdrawals from your 401(k) account.
2024 Changes to Your 401(k)
There is big news coming for 2024. Due to rampant inflation over the past several years, the IRS has increased the 401(k) employee contribution limits to:
- Tax year 2024 employee contribution limit of $23,000 (younger than 50 years old)
- Tax year 2024 employee contribution limit of $30,500 (50 years old or above)
Additionally, in 2025, to help spur 401(k) enrollment and contributions, employers will be required to automatically enroll employees in 401(k) plans (once employees are eligible). Automatic contributions will begin at 3% but not more than 10% of your gross income. For each subsequent year, your contributions will increase by 1% until you reach 10% but not more than 15%. Employees may automatically opt out of coverage4. However, automatic enrollment tends to spur higher retirement savings, and employees tend to stay in programs once automatically enrolled (and see the benefits of their savings).
Smart Summary
Saving for retirement is one of the best money habits you can form. If you prioritize saving for retirement in your twenties and thirties, reaching your retirement goals is easy. By investing in your future, you can reap the rewards and gain more financial security. Retirement savings can boost your net worth and decrease your anxiety. If you want to chat with a financial professional before beginning to save for retirement, consider consulting with a financial advisor about your financial goals. The most critical factor is to start investing and saving for retirement now.
(1) Vanguard. How America Saves 2023. Last Accessed November 18, 2023.
(2) IRS. 401(k) limited increases to 22,500 for 2023, IRA limit rises to 6,500. Last Accessed November 18, 2023.
(3) U.S. Department of Labor. A Look at 401(k) Plan Fees. Last Accessed November 18, 2023.
(4) Senate.gov. SECURE 2.0 Act of 2022. Last Accessed November 18, 2023.
