How does a 401(k) plan work? (2024)

What is a 401(k)? How does a 401(k) plan work?

A 401(k) is an employer-sponsored retirement savings plan that offers significant tax benefits while helping you plan for the future.

With a 401(k), an employee sets a percentage of their income to be automatically taken out of each paycheck and invested in their account. Participants can choose how to allocate their funds among the investment choices offered by the plan, which usually include a variety of mutual funds.

What types of employer-sponsored retirement plans are there?

There are several different types of employer-sponsored retirement plans that may include a traditional and Roth option:

401(k)
403(b)
457(b)

Traditional 401(k)

With a traditional 401(k), you fund your account with pre-tax dollars. Because your contributions are withdrawn from your paycheck before you’ve paid any taxes, your taxable income will be lower. For example, if you earned $80,000 in 2024 and you contributed $5,000 towards your 401(k), your taxable income will be reduced to $75,000.

However, when you withdraw from your account in retirement, your contributions and investment earnings are generally fully taxable. The taxes will be determined by the tax rate at the time of your withdrawal.

Roth 401(k)

With a Roth 401(k), you make contributions with after-tax dollars. This means that once you retire at age 59 ½ or later and begin taking distributions from your account, you won’t have to pay taxes on any of your contributions or earnings (not including any employer match, which will get taxed when you collect any of it).¹

Similar employer-sponsored retirement plans

If you are employed by a public school, state college, religious organization, non-profit or another tax-exempt organization, you may be allowed to participate in a403(b) plan. If you are a state or local government employee (like a teacher or police officer), you may be eligible to participate in a 457(b) plan.

These types of plans are generally similar to a 401(k) in terms ofcontribution limitsand investment opportunities.

How is a 401(k) different from an IRA?

The primary difference between a 401(k) and an IRA is that an employer offers a participant a 401(k), whereas an individual opens an individual retirement account (IRA) on their own. While IRAs don’t offer benefits like the employer match or a higher contribution limit, they may provide participants with more flexibility and investment choices than a 401(k) can.

You may be able to contribute to both your employer plan and a traditional or Roth IRA, depending on your income.

Learn more about IRA contribution limits and eligibility.

What is employer matching?

With an employer match, a company matches what an individual employee contributes to their 401(k) up to a certain amount. Most companies that offer an employer match determine how much it contributes based on a percentage of what an employee contributes.

For instance, a company may contribute 50% of the first 6% that an employee contributes. So, if your annual salary is $60,000 and you choose to contribute 6% to your 401(k) each year, you will contribute $3,600 and your company will contribute 50% of that, or $1,800. You can choose to contribute more of your salary, but your company’s match will be capped at $1,800.

Vesting

Many companies have a vesting period that determines when employer contributions belong 100% to the employee. The money you personally contribute to your 401(k) belongs to you; however, your company’s match may not be yours immediately. Many companies require a person to remain employed for three to six years before the employer matches are 100% entitled to the employee.

For example, if you leave a company after two years but the vesting period is three, your employer’s contribution to your 401(k) may go back to them — or you may receive only a percentage of it, depending on your company’s vesting schedule.

What are the 401(k) contribution limits?

For 2024, the maximum contribution limit for employees to individually contribute pre-tax (or Roth deferrals) to their 401(k) is $23,000. If you are above the age of 50², you can have a “catch-up” limit of an additional $7,500 to contribute (increasing the total if you are over 50 to $30,500). To compare, you are allowed to contribute $7,000 per year to an IRA or Roth IRA ($8,000 if you are 50 or older).

What are the 401(k) withdrawal rules?

Early withdrawal rules

While it is usually not possible to withdraw from your 401(k) while you are still working and under age 59 ½, there are certain situations when you can request a hardship withdrawal, including:

Post-secondary tuition for you or your family
Medical or funeral expenses for you or your family
Certain costs related to buying, or repairing damage to, your primary residence
Preventing your immediate eviction from or foreclosure of your primary residence

Hardship distributions of pre-tax contributions and earnings are generally subject to tax and may be subject to a 10% early withdrawal penalty, as well.¹ Hardship distributions are not eligible to be rolled to an IRA.

Loan rules

Many plans allow you to borrow up to 50% or $50,000 of your funds — whichever is less — but you have to repay the loan with interest, usually within five years. You won’t be required to pay any taxes or penalties, and any interest you pay goes back into your account. However, if you leave your current job, you may be required to pay back your loan in full in a short amount of time.

If you’ve defaulted on your loan, you’ll be required to pay taxes and a 10% penalty fee (if you left your employer prior to the year you turned 55).

Learn more about borrowing or withdrawing money from your 401(k) before you retire.

Withdrawals in retirement rules

The current age at which you’re able to withdraw without penalty from your 401(k) is 55 (if you left your employer in the year you turned 55 or later). If you left your employer before the year you turned 55, the 10% premature distribution penalty applies until age 59 ½.¹ But it’s also important to note that the IRS won’t let you keep your money in your 401(k) forever. Once you reach a certain age, you are required to begin taking required minimum distributions from your 401(k). The RMD age is 73, although you may be able to delay distributions if you are still working and not a 5% or greater owner of the business.

Learn more about required minimum distributions (RMDs).

What happens to my 401(k) when I change jobs?

When you change jobs, you are no longer allowed to contribute to your former employer’s retirement plan. If you are not yet ready to retire, you have a few options when it comes to deciding on what to do with what is left in your 401(k):

Keep the money in your former employer’s plan

While you will no longer be able to contribute earnings to it, some employers will allow you to keep your 401(k) active if you have reached a certain vested balance, which is usually more than $7,000.

Move your balance into your current employer’s plan

Doing so should come without any tax penalties and allows you to invest in a new plan.

Switch, or “roll over” to an IRA

With arollover IRA, you won’t face any tax penalties and you may be able to invest in different options not otherwise offered to you through your original 401(k). While you will no longer be making automatic contributions, this can be a flexible opportunity to have your money all in one place — especially if you’ve had multiple jobs with multiple 401(k) plans over time. It is important, however, to look at all the pros and cons of rolling over to an IRA before making a decision.

Cash out

While you can withdraw your vested amount from your 401(k) through a lump-sum distribution, you will still have to pay income tax and a 10% penalty if you left your employer before the year you turned 55 and are under the age of 59 ½, which can cost you big in the long run.²

Learn more about what to do with your 401(k) when you change jobs.

How an Ameriprise financial advisor can help

Investing in a 401(k) is an efficient way to help you reach your retirement goals and find financial support in retirement. AnAmeriprise financial advisorcan help you assess your goals, budget and current situation to determine how you can use a 401(k) to plan the retirement that is right for you.

FAQs

How does a 401(k) plan work? ›

A 401(k) is a feature of a qualified profit-sharing plan that allows employees to contribute a portion of their wages to individual accounts. Elective salary deferrals are excluded from the employee's taxable income (except for designated Roth deferrals). Employers can contribute to employees' accounts.

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How does a 401k work for beginners? ›

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.

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How do you make money on a 401k? ›

Here are 10 ways of potentially optimizing your return:

Save more than your employer's automatic savings rate.
Get a 401(k) match.
Stay until you are vested.
Maximize your tax break.
Diversify with a Roth 401(k).
Don't cash out early.
Rollover without fees.
Minimize fees.

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What are the main disadvantages of a 401k? ›

401(k) Disadvantages

Withdrawals from your traditional 401(k) are taxed at your prevailing income-tax rate when you take money out. There are restrictions on how and when you can withdraw money from the account, as well.

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What happens to my 401k when I quit? ›

Generally, you have 4 options for what to do with your savings: keep it with your previous employer, roll it into an IRA, roll it into a new employer's plan, or cash it out. How much money you have vested in your retirement account may impact what decision you make.

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How much should I put in my 401k first year? ›

For that reason, many experts recommend investing 10-15 percent of your annual salary in a retirement savings vehicle like a 401(k). Of course, when you're just starting out and trying to establish a financial cushion and pay off student loans, that's a pretty big chunk of cash to sock away.

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At what age should you start taking money out of your 401k? ›

If you leave your job for any reason and you want access to the 401(k) withdrawal rules for age 55, you need to leave your money in the employer's plan—at least until you turn 59 1/2. You can take withdrawals from the designated 401(k), but once you roll that money into an IRA, you can no longer avoid the penalty.

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Is a 401k really worth it? ›

The value of 401(k) plans is based on the concept of dollar-cost averaging, but that's not always a reliable theory. Many 401(k) plans are expensive because of high administrative and record-keeping costs. Nonetheless, 401(k) plans are ultimately worth it for most people, depending on your retirement goals.

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Who should not use a 401k? ›

If, for example, you'll be receiving pension benefits, Social Security and distributions from an IRA, throwing a 401(k) into the mix may result in a much higher tax liability. There's no way to predict the future tax rates but hedging your bets may work in your favor if there's a major tax hike down the line.

Why is a 401k not a good retirement plan? ›

Although 401(k) plans are an excellent way to save, it may not be possible to set aside enough for a comfortable retirement, in part because of IRS limits. Inflation and taxes on 401(k) distributions erode the value of your savings.

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Can I transfer my 401k to my checking account? ›

Transferring Your 401(k) to Your Bank Account

That's typically an option when you stop working, but be aware that moving money to your checking or savings account may be considered a taxable distribution. As a result, you could owe income taxes, additional penalty taxes, and other complications could arise.

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Can I close my 401k and take the money? ›

The short answer is that yes, you can withdraw money from your 401(k) before age 59 ½. However, early withdrawals often come with hefty penalties and tax consequences.

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How do I avoid 20% tax on my 401k withdrawal? ›

Deferring Social Security payments, rolling over old 401(k)s, setting up IRAs to avoid the mandatory 20% federal income tax, and keeping your capital gains taxes low are among the best strategies for reducing taxes on your 401(k) withdrawal.

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How much does a 401k grow per year? ›

That being said, although each 401(k) plan is different, contributions accumulated within your plan, which are diversified among stock, bond, and cash investments, can provide an average annual return ranging from 3% to 8%, depending how you allocate your funds to each of those investment options.

How does a 401k pay out? ›

Upon retirement, you have the option to leave your money in your 401(k), transfer it to an IRA, withdraw a lump sum, convert it into an annuity, or take required minimum distributions (RMDs) at age 73.

Do you automatically get a 401k when you start working? ›

Some employers automatically enroll new hires into a 401(k) plan. Clark said 59% of Vanguard's plans now have auto-enrollment. Employee contributions and employer matches, if offered, are invested, and the money grows tax-deferred until retirement.

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Is 401k worth putting money into? ›