401k: How does it work?

Retirement funds are the key to retirement security and independence during the later years of a citizen. While many vehicles are utilized in retirement planning, the 401k plan stands as the most popular and effective vehicle.

401k is a retirement plan sponsored by the company that allows its workers to delay a segment of salary on a tax-deferred basis generally combined with a variety of benefits including tax benefits and employer matching. The flexible vehicle allows millions of American workers to save for long-term wealth. Grasping the mechanics of a 401k from contribution through payout enables you to make smart choices that set you up for a prosperous tomorrow.

What is a 401k?

An employer-offered 401k retirement plan allows the employee to invest pre-tax income from a salary. That means the deductions taken from the income before taxation lower the income on the contribution year eligible for taxation.

It’s a defined contribution plan and thus how you accumulate depends on how much you contribute and how investments grow on what you contribute rather than on the promise of a payment under a pension.

401k plans originated during the late 1970s and have since remained a staple of retirement planning for the American economy. The great majority of plans today offer both traditional 401k features (pre-tax contribution) and Roth 401(k) features (after-tax contribution), all of which are discussed below.

What is a 401k Used For?

A vast majority of 401k plan usage is retirement saving on formal tax-benefited terms. It grows and (traditional) tax-deferred or (Roth) tax-free. Retirement income represents most typical use, although there are special accounts that include a loan or hardship distribution for special purposes. It’s used for the retirement years by time distribution.

Contributions

They choose to contribute a set percentage of compensation and have this taken out and invested within their 401k plan.

Pre-tax vs. After-tax Contributions

A standard 401k contribution is tax-deferred, decreasing taxable income. It gets taxed when distributed at retirement.

Roth 401k: You make after-tax contributions and take tax-free distributions at retirement if specific conditions are met.

Employee matching

The majority of employers will satisfy a large part of what you invest—you’re getting 50 cents on the first 6 cents of earnings. It’s basically money for nothing and a big advantage to have the ability to save for a 401k.

Investment choices

Plans typically provide a variety of funds to choose from:

• Mutual funds
• Index funds
• Target-date retirement funds
• Stock of the company (occasionally)

Vesting

Vesting represents the level of company contribution that belongs to you. You vest instantly at certain companies, while most vest on a schedule (e.g., 20 percent each year for five years).

Account development

Your investments grow based on the investments’ performance. Your regular 401(k) investments grow tax-deferred and your Roth 401k investments grow tax-free.

A withdrawable 401k plan

There are a number of ways to withdraw from a 401k, but understand the conditions and the penalty before you do.

Earliest Withdrawals

10% taxes typically go along with withdrawals before age 59½ as well as taxes on traditional 401k withdrawals.

Hardship withdrawals

Certain plans enable penalty-free withdrawals on the grounds of true hardship (e.g., sickness, eviction), exceptions and taxation likely subjecting the proceeds otherwise.

Loans

Some of these plans permit you to borrow against your 401k, generally a maximum of $50,000 or half of the vested balance. You are required to reimburse the loan, and if you don’t, you’ll be subject to penalty as well as tax.

Retirements distributions

You may make withdrawals in the regular 401k and they will be subject to taxation. Withdrawals tax-free are permitted from the Roth 401k if you have reached the age of 59½ and the plan has existed for five years.

RMDs (Required Minimum Distributions)

RMDs on a traditional 401k at age 73 (2024). Also the RMDs extend to the Roth 401(k) as a means of rolling over the funds into a Roth IRA so RMDs won’t have to be taken.

There are many advantages of a 401k

Besides acting as a retirement plan vehicle, a 401k offers a variety of benefits that also help with your overall finances and long-term goals.

• Tax benefits: Taxable income decreases through regular 401k contribution deductions; a distribution from a Roth 401k is tax-free.
• Employer matching: Free money contributed to your retirement account.
• Automated contribution is made by salary deductions.
• Investment growth: The earnings are tax-deferred or tax-free.
• Portability: You roll over the 401k at retirement or when you leave the employer.
• Your retirement income supports your retirement lifestyle.
• Financial security: Avoids sole reliance on Social Security.

Human resources applications of 401k

Human resources specialists are at the forefront of the proper management, administration, and compliance of a company’s 401k plan. Their assistance regarding such retirement benefits includes the following:

• Administration: The work of the HR staff involves sponsoring and ongoing operation of the plan on a go-forward basis, i.e., enrolling and monitoring employee contributions.
• Employee training: The HR provides material, courses, or sessions introducing the workers to how the program operates and what’s available.
• Compliance: HR guarantees compliance by adhering to the Department of Labor and IRS regulations under 401k rules such as annual tests and reporting.
• Vendor management: The HR typically outsources a third-party administrator (e.g., Fidelity) to manage the investments and administrative work of the 401k plan.

The IRS places limitations on 401k contributions.

The IRS set the 2024 contribution limit on a 401k at $23,000 for workers under the age of 50 years. For workers over the age of 50 years, a catch-up contribution of $7,500 over that level may be made for a total of $30,500. These do go up a small amount each year under cost-of-living adjustments. Saving as much as you are able to save—one of the smartest things you’ll ever do for retirement—is the goal.

Fidelity 401k

If you have a 401k account at Fidelity, you’ll have access to a wide variety of features:

• Investment choices: Diversification through mutual fund investments, index fund investments, and target-date funds.
• These tools include: retirement calculators, budget calculators, and individual planning calculators.
• Account access: Integrated web portal and mobile application.
• 24/7 customer support and finance planners at your beck and call.

401k plans offer a tax-advantaged and very effective retirement saving vehicle that includes employer matching, tax-deferred compounding, and additional contribution capacity over most other saving vehicles. Upon gaining knowledge of how 401k plans work and making intelligent decisions, workers have the ability to greatly enhance economic well-being over the long term. The key is saving as long as possible, contributing consistently, and optimizing employer contribution.