Comprehensive Guide

401(k) Plans

Introduction

A 401(k) plan is a retirement savings plan sponsored by an employer that allows employees to save and invest for their future. It's named after the subsection 401(k) of the U.S. Internal Revenue Code.

Basics of a 401(k)

Here's a comprehensive overview of what you need to know:

  • Employer-Sponsored: These plans are offered by companies to their employees.

  • Defined Contribution: The retirement benefit depends on how much the employee and/or employer contributes and the investment earnings. This is different from a defined benefit plan (like a traditional pension) where the benefit amount is predetermined.

  • Salary Deferral: Employees can choose to contribute a portion of their salary to the 401(k) account before taxes are taken out (in a traditional 401(k)). This reduces their current taxable income.

Types of 401(k) Plans

  • Traditional 401(k):

    • Contributions are made on a pre-tax basis, meaning the money is deducted from your paycheck before taxes.  

    • Your taxable income is reduced in the year you make the contributions.

    • Investment earnings grow tax-deferred.

    • Withdrawals in retirement are taxed as ordinary income.

  • Roth 401(k):

    • Contributions are made on an after-tax basis, meaning you pay taxes on the money before it goes into the account.

    • Your taxable income is not reduced in the year you contribute.

    • Investment earnings grow tax-free.

    • Qualified withdrawals in retirement (after age 59½ and having the account for at least five years) are tax-free.

Contribution Limits for 2025

The IRS sets annual limits on how much you can contribute to a 401(k). For 2025, these limits are:

  • Employee Contribution Limit (under age 50): $23,500

  • Catch-Up Contribution Limit (age 50 and over): An additional $7,500, making the total for those 50 and over $31,000.

  • Enhanced Catch-Up Contribution (ages 60-63): The greater of $10,000 or 150% of the regular catch-up limit. For 2025, this is $11,250, allowing those in this age range to contribute up to $34,750.

  • Maximum Annual Contribution (including employer contributions): $70,000

It's important to note that these are the maximum amounts you can contribute. You can always contribute less.

Employer Contributions

Many employers offer to match a portion of employee contributions. This is often a percentage of your salary or a percentage of the amount you contribute. For example, an employer might match 50% of your contributions up to the first 6% of your salary. Employer matching is essentially "free money" and can significantly boost your retirement savings over time.

Tax Advantages

Tax Deferral/Tax-Free Growth: In a traditional 401(k), your money grows tax-deferred, meaning you don't pay taxes on the earnings until you withdraw the money in retirement. In a Roth 401(k), your money grows tax-free, and qualified withdrawals in retirement are also tax-free.

  1. Reduced Taxable Income (Traditional): Contributions to a traditional 401(k) lower your current taxable income, potentially saving you money on your income taxes in the present.

  2. Potential for Lower Taxes in Retirement (Traditional): The idea behind a traditional 401(k) is that you might be in a lower tax bracket in retirement than you are during your working years.

Investment Options

Within a 401(k) plan, you typically have a range of investment options to choose from. These often include:

  • Mutual Funds: These pool money from many investors to invest in a diversified portfolio of stocks, bonds, or other assets. Common types include index funds and target-date funds.  

  • Exchange-Traded Funds (ETFs): Similar to mutual funds but often have lower fees and trade like stocks.

  • Individual Stocks and Bonds: Some plans may offer the option to invest in individual securities, although this is less common.

Your employer or the 401(k) plan administrator will provide information about the available investment options.

Withdrawals

Early Withdrawals: Generally, withdrawals before age 59½ are subject to a 10% early withdrawal penalty in addition to regular income taxes. There are some exceptions to this rule, such as for certain financial hardships.  

  1. Withdrawals in Retirement: Once you reach age 59½, withdrawals are typically taxed as ordinary income in a traditional 401(k). Qualified withdrawals from a Roth 401(k) are tax-free.

  2. Required Minimum Distributions (RMDs): For traditional 401(k)s, you will generally be required to start taking distributions from your account at a certain age (currently 73, increasing to 75 in 2032 under current law). The SECURE 2.0 Act eliminates RMDs for qualified employer Roth plan accounts and therefore Roth 401(k)s are not subject to RMD rules.

Loans

Many 401(k) plans allow participants to take out loans from their accounts. These loans have specific rules regarding the amount you can borrow and the repayment schedule. The interest you pay on the loan goes back into your 401(k) account.

Portability

If you leave your employer, you generally have a few options for your 401(k):

  • Leave it with your former employer's plan: If the balance is over a certain amount.

  • Roll it over into a new employer's 401(k) plan: If your new employer offers one.

  • Roll it over into an Individual Retirement Account (IRA): This can be a traditional IRA or a Roth IRA, depending on the type of 401(k) you had.

  • Cash it out: This is generally not recommended due to potential taxes and penalties.

Key Considerations

Participation: If your employer offers a 401(k) with a match, it's generally wise to contribute at least enough to receive the full match. This is like getting a guaranteed return on your investment.

  1. Contribution Amount: Try to contribute as much as you can afford, keeping the contribution limits in mind. Even small, consistent contributions can grow significantly over time due to compounding.

  2. Investment Choices: Understand your risk tolerance and time horizon when making investment decisions within your 401(k). Target-date funds can be a simple "set-it-and-forget-it" option that adjusts its asset allocation over time as you get closer to retirement.

  3. Fees: Be aware of any fees associated with your 401(k) plan, such as administrative fees or investment management fees. These fees can impact your overall returns.

  4. Long-Term Perspective: Retirement savings is a long-term endeavor. Avoid making impulsive decisions based on short-term market fluctuations.

Summary

A 401(k) is a powerful tool for building retirement savings due to its tax advantages and the potential for employer matching. Understanding how it works and taking advantage of its benefits can significantly improve your financial security in retirement.