How Do 401(k)s Work? Frequently Asked Questions

If you're like most Americans, when you think ''retirement planning,'' you first turn to the 401(k) plan offered by your employer. After all, it's the most common type of retirement plan out there. However, 401(k) plans can be complex, and it's not always easy to understand exactly how these plans work. 

So, what are some important things to know about a 401(k)? We've got answers to many common 401(k) questions.

A 401(k) is a tax-advantaged retirement plan that is set up and managed by an employer. Basically, you put money into the 401(k) where it can be invested and potentially grow tax free over time. In most cases, you choose how much money you want to contribute to your 401(k) based on a percentage of your income. Your employer automatically withholds a portion of each paycheck and puts it into the account.

With a traditional tax-deferred 401(k), this money is taken out of your paycheck before federal income taxes are figured, providing you the chance to reduce your taxes today. You pay ordinary income taxes on the pre-tax contributions and growth when you make a withdrawal in retirement. Note: You must be older than 59 1/2 (age 55 if you separate from your current employer) to avoid penalties on withdrawals .

Some employers offer a Roth 401(k). Contributions to these plans are made with after-tax money, which means you don't get a tax deduction. Instead, your money can potentially grow tax free and be withdrawn in retirement without any taxes. Note: To avoid penalties and/or taxes on withdrawals, you must hold the account for at least five years and be older than 59 1/2 (age 55 if you separate from your current employer).

In both types of plans, you typically have a separate account in the 401(k) registered in your name, and you'll get regular statements. Generally, you can choose from a range of investments to fit your risk tolerance and time to retirement. Each 401(k) plan tends to offer different investments, as well as whether you must pick your own investments or choose to have your account managed for you.

Your contribution to a 401(k) depends on the limits set by the IRS each year. The IRS looks at inflation to determine the annual contribution limits. For 2024, the employee deferral limit is $23,000. For those 50 or older, the IRS allows ''catch-up'' contributions of up to $7,500, for a total contribution of $30,500. 

It's a good idea to review the contributions you set up on your account annually, to ensure you’re putting away as much as possible.

One of the most important aspects of a 401(k) is the matching contributions your employer can make to your account. It’s basically a "free" contribution.

Typically, employer matching contributions are based on a percentage of the contribution you make and a percentage of your wages. For example, let's say you earn $6,000 per month, and your employer matches 50% of your contributions up to 6% of your wages. If you wanted to get the full match, you'd need to contribute at least $360 per month (6% of your monthly wages) to your account, and your employer would kick in an additional $180 (50% of $360) to match your contribution. As a result, your retirement account would see a combined contribution of $540 per month.

A common 401(k) question about employer matching is whether employer match counts toward your annual contribution limit. The good news is that it doesn't. However, there's a separate limit that affects overall contributions to your 401(k). For 2024, the combined contributions you and your employer can make to the account is $69,000 ($76,500 if you're 50 and older and making catch-up contributions). Of course, the maximum contribution can never exceed 100% of your compensation from the employer.

One of the most important things to understand is how 401(k) vesting works. Vesting is a term that describes how much of the money in your account is actually yours if you were to leave the company or take a distribution.

The contributions you make yourself are immediately vested and considered yours. However, in some companies, matching or other employer contributions aren't considered yours until you've remained with the company for a set period of time. So, if the company has a vesting schedule, you might not be able to keep all the money your employer invests on your behalf until after you've stayed at the company for the required time frame.

Generally, if you take money from your account before you reach age 59 ½, you'll have to pay taxes on the amount, plus pay a 10% penalty to the IRS. But there are some exceptions to the early withdrawal penalty.

One exception is known as the Rule of 55—if you lose (or leave) your job at age 55 or older and take distributions from the 401(k) associated with your most recent job, you won't have to pay the 10% penalty. Some other circumstances that might allow you to avoid the 10% penalty include:

• Certain qualified birth or adoption expenses
• A series of substantially equal payments
• Permanent disability

You might have to provide documentation to avoid penalty in these cases, so make sure you're prepared to do so. To learn more about the exemptions to the 10%, see the IRS website.

Yes, it's possible to contribute to both a traditional individual retirement account (IRA) and a 401(k). However, if you’re eligible to contribute to a 401(k), then your IRA tax deduction may be limited, but your IRA contribution will not. Whether you actually contribute to the 401(k) is irrelevant—merely being eligible for a 401(k) means you'll have to review your modified adjusted gross income to determine if your IRA contribution is eligible for a tax deduction. But the IRA contributions you make won’t affect your 401(k) contributions. Check out IRS Publication 590-A for an explanation of the IRA deduction rules.

How much you should contribute to your 401(k) depends on your retirement goals and how much you hope to amass in your nest egg by the time you retire. While you don't have to contribute the maximum allowed by the IRS, it's worth noting that the more you invest now, the more of a head start you'll likely have toward a comfortable retirement.

If you have more questions, be sure to ask a tax professional or financial advisor for more information about using a 401(k) to your advantage.