What Is a 401(k) Plan and How Does It Work?

401(k) is a retirement plan that offers tax benefits to both employees and employers. It helps you save for your retirement. Your employer deducts a part of your salary and deposits in your 401(k) account. The amount is invested in the market to provide you a source of income when you retire. You don’t have to worry about managing the investment since your employer does it for you.

How does a 401(k) plan work?

401(k) Plan

Once you subscribe to a 401(k) plan, your employer automatically deducts your contribution from your paycheck (before it is taxed) and deposits it in your 401(k) account. The employer may also contribute some amount from their side although they are not legally obliged to do so. The employer then invests the money in the market according to your directions and rules of the plan.

The investments thus continue to grow in your 401(k) account without attracting any federal taxes so long you do not withdraw the funds. A 401(k) administrator oversees the management of the account.

For example, if you get a paycheck of $1,000 per week and contribute 10 percent to a 401(k) plan, then your employer will deduct $100 from your salary each week and deposit it in your 401(k) account. For the purpose of federal taxation, you will be taxed only on the remaining salary of $900 per week. However, you may have to pay state taxes depending upon the tax laws of your state.

Contributions made by all the employees of a company build up into a huge pile of money. Companies usually hire a fund manager to analyze the market and invest the money into a portfolio of funds that is safe and lucrative. You can choose from a number of investment portfolios depending upon your taste for risk and earning.

Thus, the working of a 401(k) plan can be summed up as follows:

  • You subscribe to the 401(k) plan of your employer and determine the percentage of salary you wish to contribute.
  • Your employer deducts the stipulated amount from your paycheck and puts it into your 401(k) account.
  • Depending upon your salary structure, your employer may contribute a certain sum of money to the plan from their side.
  • The employer invests the amount of your 401(k) account in shares, debentures, mutual funds, etc. according to your directions.
  • A fund manager manages the investment so as to maximize profits and minimize the associated risks.
  • You save taxes on the amount of salary you contribute to the 401(k) plan.
  • You pay taxes when you withdraw money from your 401(k) account.

What are the main features of a 401(k) plan?

Following are the characteristic features of a 401(k) plan:

  • Any type of business ranging from a sole proprietorship to a corporation can set up a 401(k) plan. Your employer is called the sponsor of the plan.
  • Your employer specifies the eligibility criteria for participating in the plan. These criteria must be within the applicable rules and regulations.
  • Based on the eligibility criteria, employees that have been with the company for less than a year, part-time employees, non-US citizens, etc. may not qualify for the plan.
  • Your employer may choose to make a voluntary contribution to your 401(k) account. They may also establish a vesting schedule (time when you become the rightful owner of the money) for their contribution.
  • Your employer may also receive some tax benefits for their contributions to the plan.
  • Federal income tax on your contributions to the plan is deferred until the time of withdrawal. In other words, in the year of contribution, you pay income tax only on your remaining salary after deducting the contribution. In the year of withdrawal, you pay tax on the amount withdrawn at the rates applicable for that year.
  • Each plan has its own investment choices but most of the plans give you eight to 25 investment options.
  • A few plans may allow you to purchase company stock.
  • 401(k) plans must be non-discriminatory and comply with the top heavy test. A top heavy test sees whether a plan is balanced between key employees and non-key employees.
  • Your employer may appoint a vendor to administer the account. The vendor so appointed is usually responsible for all the accounting, reporting and filing requirements.

How much can you contribute to your 401(k) account?

Employees’ contribution limits for a 401(k) plan change every year. As of 2018, you can contribute up to $18,500 of your salary into your 401(k) account. If you are over 50 years, you can contribute an additional sum of $6,000, thus taking your contribution limits to $24,000.

If your employer also contributes to your 401(k) plan, you should consider contributing enough amounts to qualify for maximum contribution from your employer. Talk to someone from your company’s human resource department to find out the maximum contribution your employer can match. However, also keep in mind that you will not be able to access the money in your 401(k) account (without attracting a withdrawal penalty) anytime before you reach an age of 59.5 years.

Who administers your 401(k) account?

Your employer manages your 401(k) account on your behalf. Your company may either appoint a fund manager to manage the investment or appoint an external fund management agency. Your contribution along with your employer’s contribution, if any, is directly deposited in your 401(k) account and the money is invested in mutual funds and securities of your choice.

You can choose to invest in one or more funds that your plan offers. Most of the plans give you at least three different options with varying risk levels. You can get the information about your investment choices from your company. If an external administrator is managing your account, your company may also give you their contact details for further help.

Many plans let you set up a default preference so that you don’t have to give investment directions every pay period. Unless you intimate your company or account administrator of a different preference, your money is automatically invested in your default funds.

What if you need the money before you retire

Any withdrawal made before you reach the age of 59.5 years will be subject to an early withdrawal penalty of 10 percent in addition to the regular taxes applicable at the time of withdrawal. However, depending upon the rules of your plan, you may be able to get a waiver of withdrawal penalty in certain cases of hardship withdrawals, like in case of sudden disability, medical expenses exceeding 10 percent of your income, etc.

Many plans also allow you to take a loan against your funds in the 401(k) account. However, you must repay the loan within the stipulated period, which is usually a few years. If you leave your job, you will have to repay the loan within a few months.

401(k) plans help you achieve your retirement goals. Tax deferment and easy portability have made them quite popular among employees.