How does a 401(k) work?

Published Jan 19, 2020  ∙  Updated Aug 21, 2022

Let’s try and simplify everything we need to know about the most common retirement savings account, the 401k.

Definition

The 401k is an employer-sponsored investment account that you can contribute to every single pay period for retirement.

  • Money Restriction: As of 2022, those under the age of 50 can contribute up to $20,500 per year and those ages 50 and above can contribute up to an extra $6,500 per year.
  • Age Restriction: Once the money is put into this account, you cannot withdraw it until you are 59.5 years old, but you will be forced to take distributions (withdrawals) by the time you are 70.5 years old, also known as Required Minimum Distributions (RMD).
  • Penalty: If you withdraw funds before that age, that money will be taxed as ordinary income and the IRS will impose a 10% penalty.
  • Tax-Advantage: The 401k is what is known as a tax-deferred account.

There are 3 ways you can obtain tax benefits in any investment account:

  1. When you put money in
  2. When your money grows
  3. When you take money out

The term “tax-deferred” takes advantage of numbers 1 and 2.

  1. Tax-Free Contributions: the money you place in your account is not taxed (pre-tax money)
  2. Tax-Free Growth: gains from growth, dividend payouts, and accumulated interest are not taxed
  3. Taxed Withdrawals: distributions, or funds you withdraw, are taxed

Because the money you put in is pre-tax, the income you receive is lower, thereby lowering your taxable income. That means your income tax will be lower that year.

Key Points

  • The 401k is an employer-sponsored retirement account
  • We can only withdraw money after the age of 59.5
    • If we withdraw earlier, we will pay income tax plus a 10% penalty
  • Those under 50 can contribute $20,500/yr
  • Those 50 and can contribute an extra $6,500/yr
  • The 401k is tax-deferred

Eligibility

In order to be eligible for a 401k, you need to be employed and your employer must offer one.

While employers may offer a 401k plan, you must opt-in and manually set the amount you want to contribute.

Employers will often provide what they call 401k matching, which means that your employer will also contribute to your 401k account.

You might see the phrase: “We will match dollar-for-dollar up to the first 6%”.

That means for every dollar you put in, your employer will put in a dollar (that is double the money). They will only do this, however, until you’ve contributed 6% of your agreed salary.

You might also see: “We will match 50% of your contribution up to the first 3%”.

Intuitively, that means for every dollar you put in, your employer will put in 50 cents until you’ve contributed 3% of your salary.

It is recommended that you always at least contribute up to what the employer matches. In the scenarios above, that would be 6% and 3% of your salary, respectively.

Other Things To Know

1. There Are Fees For Your 401k

Yes, there are fewer taxes, but you won’t be collecting every single penny your investments make.

Every single year, your money manager will take a percentage of your total assets as a fee whether or not you make money.

These fees include investment fees, plan administration fees, individual service fees, etc.

2. Diversify Your Assets

When people think of diversification, they often think about investing in different funds, which is important.

You never want to put all your eggs in one basket. Don’t use all your money to buy a single stock, but perhaps buy index funds that track the entire market or follow the three-fund portfolio.

That being said, having a 401k be your only investment means that if you retire when the stock market is down, then you gotta wait years for it to get back up, delaying your retirement.

Be sure to diversify your assets (e.g. real estate, savings accounts, CDs, cash, 401k, etc.)

3. Don’t Be Fooled By “Tax-Deferred”

Yes, the money you put into your 401k is tax-free, but it’s “income tax-free”, so you still pay social security and medicare tax on your contributions.

Also, don’t forget that you will still pay an income tax. It’s only tax-free when you contribute. When you withdraw, you will be subject to your appropriate income tax rate for that year.

When you’re in retirement, you may not have any income, so your tax rate may be low, but do not plan to have no income. Build up passive income sources so that you can live an even more comfortable retirement and potentially give more to local churches, charities, your family, or your friends.

Don’t not put money into your 401k for this reason, though. Yes, you’ll be taxed, but you’ll still have more money than if you let your money sit in a checking account.