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how does 401k work: an account is a piggy bank for retirement

Of the different kinds of employer-sponsored retirement savings plans, 401(k) plans are the most common. Indeed, an estimated 80 million Americans actively participate in defined contribution plans such as 401(k)s. But you can expect to see this number rise, thanks to the SECURE Act, which was signed into law at the end of 2019. The act requires companies that offer 401(k) plans to extend the benefit to part-time workers (who work 500 hours per year for three consecutive years). A financial advisor could help you create a financial plan to reach your retirement goals. Let’s break down how 401(k) plans work and how to get the most out of your retirement savings account.

What Is a 401(k) Plan?

A 401(k) plan is a workplace retirement savings program, sponsored by a private employer and offered to employees as part of their general benefits package, alongside perks like vacation days and healthcare coverage. While there is no law requiring workplaces to offer a retirement savings plan to employees, there are laws governing how 401(k)s are administered. The primary law is the Employee Retirement Income Security Act (ERISA) of 1974.

Companies create 401(k) plans with financial service providers. The plan offers an array of investment options, often mutual funds, though the SECURE Act puts annuities into play. Eligible employees decide if they want to participate – the plan is completely voluntary, though you may have to opt out if your company automatically enrolls you. If you do want to participate, your contribution amount, often expressed as a percentage of your pay, is up to you. (Though again, your employer may have an automatic default percentage that you will have to change if it is too high or low.) Likewise, it’s your call how you invest your money.

Another benefit some companies offer to employees is an employer match. This means that the company will match a percentage of the money that employees contribute to their 401(k) account. This could be a straight match, which is when a company offers a full match for up to a certain percentage of an employee’s annual income. More commonly it’s a partial match, where a company offers to match a percentage of an employee’s contributions, up to a cap.

The maximum amount you can contribute to a 401(k) plan has been steadily rising. The max is $19,500 for 2020 and 2021.

Taxes and 401(k) Plans

how does 401k work: a nest egg with 401k written in gold

Tax treatment is what makes 401(k) plans so attractive. Dollars you put in the plan do not count toward your taxable income. You don’t pay taxes on them until you retire and start making withdrawals. (There are newer Roth 401(k) plans, where you pay taxes on your contribution – and your withdrawals are completely tax-free, including earnings.) The appeal of deferring taxes is that you will likely be in a lower tax bracket when you retire.  Also, some states exempt or partially exempt money withdrawn from retirement accounts from the state income tax.

That said, if you are at the beginning of your career or working part-time, you may not want to defer taxes. After all, you’re probably now in a lower tax bracket than you will be in retirement. If that’s the case, you should contribute to a Roth 401(k) if it’s available. If it’s not an option, though, you should then contribute to the traditional 401(k) – especially if your employer offers a match. Not taking the match is like leaving money on the table.

401(k) Plan Investments

Typically, 401(k) plans offer mutual funds, exchange-traded funds (ETFs), individual stocks and bonds as investment options. If your employer is a publicly traded company, you may be able to buy company shares in the plan. And as noted earlier, thanks to the SECURE Act, annuities will start appearing on more 401(k) menus.

Mutual funds and ETFs, which invest in a number of different securities, are the predominant investment options in 401(k) plans  That’s because the risk is diluted among the different securities – and possibly different sectors. When a fund is passively managed, it tracks a certain stock index and generally goes up and down as the market does.

401(k) Withdrawal Rules

You can’t withdraw money from a 401(k) plan until you turn 59 1/2. Any withdrawals you make before then are subject to ordinary income taxes and a 10% penalty. There are some exceptions, however, including death, disability or a qualified domestic relations order following a divorce.

If you really need to take money out of your 401(k) before you reach retirement age, some companies will allow you to borrow from your account. You pay back the money over a period of time and the interest rate is low. The biggest risk to this is that if you lose your job and are no longer part of the plan, you must pay back the loan within 60 days. If you don’t pay it back in full, the loan is treated as an early withdrawal.

How to Open a 401(k) Plan

how does 401k work: envelope of cash designated for a 401k plan

You can’t participate in a 401(k) plan unless you work at a company that offers one. Ask the human resources department if your company offers one. They will also have information on enrollment.

Once you receive the relevant information from someone at your company, you can open an account. This will require some basic information, like your Social Security number. Once your account is established, you’ll designate what percentage of each paycheck you want to contribute to your account and where you want to invest the money. You’ll also pick a beneficiary, likely a spouse or another close family member, who will receive your money in the event of your death.

The Bottom Line

A 401(k) plan is a common way to save for retirement. Employers sponsor 401(k) plans and employees invest pre-tax money. Investment options include stocks and bonds, but most people choose to invest in less risky options like mutual funds and ETFs, which are inherently diversified. Some companies may even offer an employer match, free money based on how much you save.

Retirement Tips

  • A financial advisor can help you figure out how to maximize your 401(k) savings. SmartAsset’s free tool connects you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors, get started now.
  • Do your research to make sure you’re making the best retirement choice for your needs. Here’s a breakdown of IRAs vs. 401(k)s.
  • Don’t forget that you’ll get a Social Security check from the government in addition to your own retirement savings. See how big of a payment you can expect using SmartAsset’s free Social Security calculator.

Photo Credit: © iStock/DNY59, © iStock/designer491, © iStock/jygallery

Ben Geier, CEPF® Ben Geier is an experienced financial writer currently serving as a retirement and investing expert at SmartAsset. His work has appeared on Fortune, Mic.com and CNNMoney. Ben is a graduate of Northwestern University and a part-time student at the City University of New York Graduate Center. He is a member of the Society for Advancing Business Editing and Writing and a Certified Educator in Personal Finance (CEPF®). When he isn’t helping people understand their finances, Ben likes watching hockey, listening to music and experimenting in the kitchen. Originally from Alexandria, VA, he now lives in Brooklyn with his wife.
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