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How Does a 401(k) Work?

Key facts

  • 401(k) plans are employer-sponsored retirement savings plans.
  • Contributions are tax-deferred and distributions are taxed in the year they are taken.
  • Withdrawals before the age of 59½ may be subject to a 10% early withdrawal penalty.

401(k) plans are retirement savings plans named after the portion of the IRS tax code that created them, and they are exclusively designed to help businesses support their employees in saving for retirement. While employers have some flexibility in how their company 401(k) plans are administered, the basic rules are the same. Participating in your company’s 401(k) is an easy way to save for retirement. In many cases, company also offer matching contributions, which ends up being a boost to your total compensation.

401(k) Rules: The Basics

401(k) programs aim to offer employees a retirement savings account that is easy to use. Employers take care of nearly all of the logistics, from account setup to selecting the plan’s administrator. Employers typically offer a limited number of investment options, and plan administrator often offers tools to help you understand how much you should be saving and which investment strategy best suits you.

Once the plan meets the requirements to qualify as a 401(k), a company can put forth very few restrictions on participation. There are three permissible exclusions, and companies can choose to make their plan rules less restrictive if they wish. First, companies can require all participants to be at least 21 years old. Second, companies can require that employees have a year of service before they are able to participate. Third, companies can exclude employees in some circumstances if they are covered by collective bargaining agreements.

401(k) Rules: Contributions

Your contributions are taken directly from your paycheck on a pre-tax basis, so you don’t pay income taxes on your contributions or their earnings until you withdraw funds from your account.

In many cases, organizations that sponsor 401(k) plans offer matching for a percentage of your contributions. For example, companies might offer to match 50 cents for every dollar you save, up to 5% of your income. If your salary is $50,000 per year and you save 8% of your pre-tax income ($4,000), your employer would add $1,250 to your account. This amount is also tax-deferred. One caveat: employers can require that you stay with the company for a certain amount of time before you take ownership of the employer’s contributions, which is called vesting. You always retain ownership of funds you contribute.

There is a limit to the amount you can contribute each year. These limits are reviewed annually, and the maximum amount currently is $18,000. Participants aged 50 and older may be permitted to make catch-up contributions of an additional $6,000 per year if their employer plan allows for it.

401(k) Rules: Withdrawals

Employers have some control in determining the conditions under which employees can withdraw from their 401(k) accounts, but there are certain requirements that all plans must follow. Withdrawals must be permitted under the following circumstances:

  • The employee becomes disabled.
  • The employee dies and the beneficiary is making withdrawals.
  • The employee reaches age 59½.

Taxes apply to all withdrawals. If financial hardship arises and an employee must make withdrawals before age 59½, an additional 10% penalty may be applicable. Employees must take required minimum distributions (RMD) when they reach age 70½, with the exception being if they are still employed and the employer doesn’t require RMDs to be taken. Penalties for failing to take your RMD can be as much as 50% of the RMD amount, so it is important to calculate and withdraw according to IRS regulations. The IRS provides calculation worksheets to make determining the correct RMD easier.


Disclosure

Nothing in this article should be construed as tax advice, a solicitation or offer, or recommendation, to buy or sell any security. This article is not intended as investment advice, and Wealthfront does not represent in any manner that the circumstances described herein will result in any particular outcome. Financial advisory services are only provided to investors who become Wealthfront clients.

This article is not intended as tax advice, and Wealthfront does not represent in any manner that the outcomes described herein will result in any particular tax consequence. Prospective investors should confer with their personal tax advisors regarding the tax consequences based on their particular circumstances. Wealthfront assumes no responsibility for the tax consequences to any investor of any transaction. Investors and their personal tax advisors are responsible for how the transactions in an account are reported to the IRS or any other taxing authority.

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