What Is a 401(k) Plan? Everything You Need To Know

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About 70% of Americans contribute to some kind of retirement plan, according to data from financial services company, Empower. Many of these plans are company-sponsored 401(k)s, with median balances ranging from less than $30,000 for workers in their 20s to nearly $250,000 for workers in their 50s.

The decline in private pension plans in recent decades has made 401(k) plans the best and often only option for U.S. workers who want to build a retirement fund through their employers. 401(k) plans offer tax-deferred savings and let you build your nest egg in a hurry thanks to matching employer contributions. Keep reading to learn more.

What Is a 401(k) Plan?

A 401(k) plan is a retirement account offered by employers. Workers who sign up for the plans agree to have part of their earnings deducted from their paychecks and put into the 401(k). The deductions are pretax, which means that they come out of the paycheck before taxes are deducted. Pretax deductions lower an employee’s taxable income, meaning you’ll pay less in taxes that year.

401(k) retirement plans also have benefits for employers — mainly as a way of competing for the best workers. Employers also can deduct contributions from their federal income taxes.

Here are some other important things to know:

• 401(k) plan sponsors offer a variety of investment options, including stocks, bonds and mutual funds.
• Employees decide which investments they want and allocate funds toward those investments.
• Employees don’t pay taxes on contributions or interest until withdrawal.
• Employees can contribute to both a 401(k) and an individual retirement account in the same year.

How Does a 401(k) Work?

Employers typically act as plan sponsors for 401(k)s and hire third-party administrators to oversee the accounts. If your employer offers a 401(k) plan, it will tell you when you can enroll. In some cases, you can enroll right away, while in others you will have to wait until you finish a probationary period.

When you enroll, you’ll be able to choose how much money you want to contribute and how those funds are invested. There’s a limit to how much you can contribute, however.

Some employers match your contributions, so keep that in mind when you decide how much to contribute. For example, your employer might match your contributions for up to 5% of your income. Matching funds might not be available immediately due to “vesting,” which requires you to wait a certain period of time before the matching funds are yours.

If you do get matching contributions, you should aim to contribute up to the limit if possible because the employer match equals free money in your account.

What Is the Maximum 401(k) Contribution?

There is a limit to how much you can contribute in a given year. In 2024, the contribution limit for employees who participate in traditional 401(k) plans is $23,000, up from $22,500 in 2023, according to the IRS.

Once the employee’s 2024 income reaches $345,000, the employee and employer can no longer contribute to the 401(k) account.

There are also maximums as to how much can be contributed to a 401(k) by both the employer and employee. In 2024, the maximum for overall contributions is the lesser of the employee’s annual compensation or $69,000.

What Is a 401(k) Catch-Up Contribution?

When you reach a certain age, the IRS allows you to make “catch-up” contributions to your (401)k so you can increase your savings as you approach retirement. In 2024, the catch-up contribution for employees 50 and older is $7,500 for traditional 401(k)s. This means you can contribute up to $30,500 for the full year if you meet the age requirements. For employees aged 50 and older participating in SIMPLE plans, the catch-up contribution limit is $3,500.

What Are the Types of 401(k) Plans?

Employers can offer several types of 401(k) plans, including the following:

• Traditional 401(k) plans: With traditional 401(k) plans, employers can make contributions to all participants, match employee contributions, or both. They also can use a vesting schedule and must pass an IRS test to ensure they’re not favoring high earners.
• Safe harbor 401(k) plans: With these plans, employer contributions are vested right away. In other words, once your employer contributes funds, those funds are yours.
• SIMPLE 401(k) plans: These are 401(k) plans for small businesses that don’t have to pass the IRS test for traditional 401(k) plans. Employer contributions are vested immediately.
• Roth 401(k) plans: Roth 401(k) plans allow employees to contribute on an after-tax basis. With a Roth 401(k), you don’t have to worry about paying taxes when it’s time to withdraw funds from the account.

Can You Withdraw Money From a 401(k) Plan?

When it comes to when you can withdraw 401(k) funds, age 59½ is the magic number. That’s the age that serves as a cutoff for having to pay early withdrawal penalties. Here’s what you need to know.

Withdrawals Before Age 59½

In general, if you make withdrawals before age 59½, you pay a 10% early withdrawal penalty plus income taxes. But there are exceptions. For example, many plans allow hardship distributions, though you might need to prove that you’re experiencing a hardship such as high medical bills or a looming foreclosure. If you provide adequate proof, you can withdraw the funds without the early withdrawal penalty.

Withdrawals After Age 59½

Once you reach age 59½, you can withdraw funds without a penalty, but you can also wait. Just don’t wait too long. At a certain age, you will face a required minimum distribution, or RMD, which means you must begin withdrawing funds from the 401(k) or face a penalty. In 2024, the RMD is age 72 or 73 if you reach age 72 after Dec. 31, 2022.

401(k) Pros and Cons

Although 401(k) plans are a popular form of retirement savings, they’re not perfect. Here’s a breakdown of the advantages and disadvantages.

Pros

• Tax-deferred growth
• Automated savings because the money is automatically withheld from your paycheck, so you don’t have to worry about making deposits yourself
• Matching employer contributions that provide free money to the 401(k)

Cons

• Yearly contribution limits
• Early withdrawal penalties
• Potential for losses if the investments in your 401(k) don’t do well

What Happens to Your 401(k) When You Leave Your Employer?

If you leave your employer, you have a few options when it comes to your 401(k) — including leaving the account with your former employer. That’s not the best option, however. You are better off rolling it over to your new employer’s plan if they have one. This can be done with no penalties.

If your new employer doesn’t offer a 401(k) plan, you can move your 401(k) into a personal IRA. If you choose a traditional IRA, you won’t have to pay taxes with the rollover, but with a Roth IRA you will owe taxes.

Cynthia Bowman and Vance Cariaga contributed to the reporting for this article.

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