How Do 401(k)s Work? 8 Frequently Asked Questions

If you're like most Americans, when you think "retirement planning," you first turn to the venerable 401(k) plan. After all, it's the most common type of retirement plan. However, even though many workers use a 401(k) to save for the future, it's not always easy to understand exactly how these plans work.

So, how does a 401(k) work? We've got answers to some of the most common 401(k) questions.

Here's the 401(k) explained: You put money into a retirement plan sponsored by your employer, where the money is expected to grow with a tax advantage 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.

With a traditional 401(k), this money is taken out of your paycheck before federal income taxes are figured, providing you the chance to reduce your taxes today. You pay taxes on the money when you withdraw it from your account during retirement. In exchange for this increased tax efficiency, you agree to hold off on any withdrawals (without penalty) until you reach age 59 ½.

Some employers offer a Roth 401(k). In a plan that allows Roth contributions, you don't get an immediate tax deduction because Roth contributions are made with after-tax money. Instead, you expect your money to grow tax-free, and you can withdraw it without paying taxes.

In both types of plans, you typically have a separate account in the 401(k) registered in your name, and you'll get regular statements. Typically, you can choose from a menu of investments to pick which plan works best for your age, risk tolerance, and time to retirement. Each 401(k) plan will be different in the investments offered, as well as whether you must pick your own investments or choose to have your account managed for you.

How much you can contribute to a 401(k) depends on the limits set by the IRS each year. The IRS looks at inflation and other market-related factors to determine limits on annual contributions. For 2023, the limit is $22,500. For those 50 or older, the IRS allows "catch-up" contributions of up to $7,500 above the $22,500 limit for 2023.

It's a good idea to review the annual limits each year because they often change. If you're already contributing the limit, and it rises, you might want to adjust your contributions in the new year to boost your savings.

One of the most important aspects of a 401(k) is the effect of matching contributions made by your employer, which adds "free money" to your account.

Typically, an employer match works by taking a portion of your contribution, up to a certain percentage of your income, and investing it in your 401(k). Most matches are expressed as a percentage of the contribution you make and are based on a percentage of the income you choose to contribute. For example, let's say you earn $6,000 per month, and your employer matches 50% of your contributions up to 6% of your income. If you wanted to get the full match, you'd add at least $360 per month (6% of your monthly income) to your account, and your employer would kick in an additional $180 to match your contribution. As a result, your retirement account would grow by $540 each month.

A common 401(k) question about employer matching is whether the employer match counts toward your annual contribution limit. The good news is that it doesn't. However, there's a separate limit that affects overall contributions. For 2023, the combined contributions you make plus your employer contributions cannot exceed $66,000 ($73,500 if you're 50 and older and making catch-up contributions). Of course, the maximum contribution can never exceed 100% of the participant's actual compensation from the employer.

One of the most important things to understand is how 401(k) vesting works. Vesting is a term that describes how much of the money in your account is actually yours if you were to leave the company or take a distribution.

The contributions you make yourself are immediately vested and considered yours. However, in some companies, matching or other employer contributions aren't considered yours until you've remained with the company for a set period of time. So, if the company has a vesting schedule, you might not be able to keep all the money your employer invests on your behalf until after you've stayed at the company for one, three, or six years, for example.

Generally, if you take money from your account before you reach age 59 ½, you'll have to pay taxes on the amount at your marginal federal tax rate, plus pay a 10% penalty to the IRS. But there are some exceptions to the early withdrawal penalty.

One exception is known as the Rule of 55—if you lose (or leave) your job at age 55 or older, and you take distributions from the 401(k) associated with your most recent job, you won't have to pay the 10% penalty. Some other circumstances that might allow you to avoid the 10% penalty (but not the taxes) include:

• Substantial medical bills
• Military service
• Permanent disability
• A "qualified domestic relations order," such as in a divorce settlement

You might have to provide documentation to avoid penalty in these cases, so make sure you're prepared to do so.

Yes, it's possible to contribute to both an individual retirement account (IRA) and a 401(k). However, if you’re eligible to contribute to a 401(k), then your IRA deduction (not contribution) may be reduced depending on your income. Whether you actually contribute to the 401(k) is irrelevant—merely being eligible for a 401(k) means you'll have to review your modified adjusted gross income to determine your IRA deduction. But any IRA contributions you make do not affect your 401(k) contributions, nor the taxation of your 401(k) contributions. Review IRS Publication 590-A for an explanation of IRA deduction rules.

Sometimes the issue of how a 401(k) works is less about the mechanics and more about how much you can contribute. How much you end up contributing to your 401(k) depends on your retirement goals and how much you hope to amass in your nest egg by the time you retire. While you don't have to contribute the maximum allowed by the IRS, it's worth noting that the more you invest now, the more of a head start you'll likely have toward a comfortable retirement.

If you have more questions, be sure to ask a tax professional or financial advisor for more information about using a 401(k) to your advantage.