What is a 401(k) plan and how does it work

If you’re just entering the workforce, or you’ve been working for a while but put off saving for retirement, one of the easiest ways to get started is by contributing to an employer-sponsored 401(k) plan. Many companies offer this type of retirement savings plan to employees as part of their benefits package link opens to a Commerce page. There are multiple reasons to participate in a 401(k) plan, from tax advantages to employer matching and more.

What is a 401(k) plan?

A 401(k) plan is an employer-sponsored retirement savings plan that lets employees contribute a portion of their salary into a long-term investment account through regular, automatic paycheck deductions. A 401(k) plan can be part of an overall retirement strategy that diversifies your assets so you can get the most out of them while reducing your tax burden. In some cases, the employer may match a portion of the employee contribution.

How does a 401(k) plan work?

401(k) plans were created to help employees save for retirement link opens to a Commerce page while also enjoying tax benefits. If your employer offers a 401(k) plan, here’s what you need to know about joining, choosing and contributing to it.

Eligibility. Some company policies allow employees to sign up for a 401(k) as soon as they’re hired, while others may require a waiting period. Talk to your human resources department to confirm your company’s eligibility requirements.

Types of 401(k) plans. There are two main types of 401(k) plans — traditional and Roth. If both plans are offered by your employer, you may have the option to contribute to one or the other, or split contributions between both. Each type offers tax advantages, but the primary difference is the way contributions and withdrawals are taxed.

“Contributions to a traditional 401(k) are pre-tax but you pay taxes on withdrawals. With a Roth 401(k), you pay taxes now, but the money grows tax free, and withdrawals are tax free,” says Chris Ward, Executive Vice President and Financial Advisor with Commerce Financial Advisors. When deciding which type to contribute to, he recommends considering your age, as well as your tax bracket now and what it might be when you want to retire.

Investment choices. Most 401(k) plans offer employees a selection of investment options. It’s a good idea to educate yourself on the options available to you so you can make the best decision for your goals. Ward recommends working with a financial advisor when considering your choices. “If you don’t have access to an advisor, then a target date fund, which lets you align your investment allocations with your estimated retirement date, can be an easy way to get invested,” he says.

Another option for new investors is a model portfolio that recommends options based on your responses to a questionnaire.

“If you’re eligible to participate in your company’s 401(k), the most important thing is to be invested and be in it for the long term,” adds Ward.

Employee contributions. The maximum amount an employee can contribute may depend on the plan, their salary and government guidelines. Employees age 50 and older can make additional catch-up contributions. For 2022, the annual employee contribution limit to a 401(k) account is $20,500 and the catch-up limit is $6,500.¹

Employer contributions. Your employer may choose to contribute to your 401(k) plan. If so, they may match a portion or percentage of your contribution, such as a 100% match on the first 5% you contribute. Or an employer may opt to contribute based on a percentage of your salary.

Vesting. The money that you contribute to your 401(k) plan will always be yours, but your employer’s contribution may be subject to a vesting schedule. This means that a set period, such as a certain number of years of employment, may be required before the money your employer contributes is fully yours.

What are the benefits of contributing to a 401(k) plan?

“One major benefit is the employer match,” says Ward. “It’s like getting free money. Contributing up to the match is one of the best ways an employee can take full advantage of this benefit,” he adds.

Providing an easy, tax-advantaged method of saving for retirement, plus the ease of automatic deductions from your paycheck to your account, are also benefits of participating in your employer’s 401(k) plan.

Three key 401(k) facts to know

1. Withdrawal rules. A 401(k) plan is meant to be a retirement savings plan, which means you can’t withdraw the funds until age 59½ or you meet other criteria outlined by the IRS. If you do need to withdraw the funds earlier, you’ll pay a 10% penalty tax as well as income taxes. This comparison chart link opens in a new window from the IRS explains the withdrawal rules in more detail for Traditional 401(k) versus Roth 401(k) plans.
   
   
2. Borrowing from your 401(k). Some plans let you borrow link opens to a Commerce page from your 401(k) contributions, tax free. Certain restrictions apply, such as repaying the loan in full within a specified amount of time. Keep in mind that borrowing from your plan will decrease the amount of money that’s been earning interest, potentially leaving you with a smaller overall balance.
   
   
3. What happens when you leave your job. Ward notes that if you leave your job, you may have the following options for your account balance: Move it to an Individual Retirement Account (IRA), move it to your new employer’s plan, keep it with your current employer or withdraw the money from your account. “If you’re not immediately sure which option is best for you, you have 60 days to take the funds and transfer them into one of the options above,” he says. Your financial advisor can help you understand the pros and cons of different options.

It’s never too early to start saving for retirement. Contributing to your employer’s 401(k) plan can be a simple way to get started and enjoy the peace of mind that comes with knowing that you’re preparing for your future. If you’re just beginning to save for retirement, it’s okay to start with small contributions and gradually increase amounts — for example, whenever you get a raise.

For questions about your eligibility, plan types and investment options, contact your employer’s human resources department. You can also find helpful 401(k) information and resources on the websites for the Internal Revenue Service link opens in a new window and U.S. Department of Labor link opens in a new window.

Commerce Financial Advisors is here to help with your retirement questions and financial goals. To learn more or to find a financial advisor near you, contact us link opens to a Commerce page.