What Is a 401(k) Retirement Plan?

By Allison Martin Last updated Jan 28, 2020

If you’ve ever conversed with a financial advisor about retirement, chances are there was some mention of the term, 401(k) plan. While you may be well aware that it’s a type of retirement plan, there’s also a chance you aren’t exactly sure what they entail, if you’re eligible, or if it’s something your employer even offers.

But don’t fret. In this guide, we’ll answer these questions and so much more.

401(k) Plans, Defined

According to IRS.gov, “a A 401(k) plan is a qualified plan that includes a feature allowing an employee to elect to have the employer contribute a portion of the employee’s wages to an individual account under the plan.”

In other words, it’s a retirement plan that allows you to contribute a percentage of your pre or post-tax earnings into an investment portfolio to build your nest egg. This means you’ll either save on taxes now or later, depending on which type of 401(k) plan you choose.

Plus, it affords you the opportunity to grow your retirement savings at an even faster rate as some employers offer matching contributions as an incentive of working for their company.

And you’ll have a say in how your money’s invested as you’re afforded the opportunity to decide on asset allocation strategy that best suits your needs. If you’re unsure of which spread is best, you can always connect with your plan administrator for additional guidance.

Types of 401(k) Plans

There are four types of 401(k) plans you should be aware of.

Traditional 401(k) Plan

Traditional 401(k) plans allows employers to make elective deferrals on a pre-tax basis through payroll. Employers also have the option to provide what’s referred to as matching contributions, which is usually based on the amount the employee contributes (up to a certain amount) or a blank amount companywide.

Roth 401(k) Plan

Roth 401(k) plans are structured like traditional 401(k) plans. However, elective deferrals are made on a post-tax basis. This means that you won’t derive the benefit of lowering your taxable income right now. However, you won’t be subject to federal income tax when you take distributions, which can be beneficial if you anticipate being in a higher income tax bracket several years down the line when you retire.

Safe harbor 401(k) Plan

Safe harbor (401) plans operate in the same manner as traditional 401(k) plans, but the key difference is in the vesting. “It must provide for employer contributions that are fully vested when made,” notes IRS.gov.

Simple 401(k) Plan

Simple 401(k) plans cater to employees of small businesses and similar to a safe harbor 401(k) plan, mandates that all contributions made on the employers behalf are fully vested. To qualify, the small business you are employed with must not have more than 100 employees that were compensated $5,000 or more in the prior calendar year.

Contribution Limits

The annual contribution limits for 401(k) plans are as follows:

Traditional 401(k) plans: $19,000 (plus $6,000 in catch-up contributions if you are 50 or older)
Safe harbor 401(k) plans: $19,000 (plus $6,000 in catch-up contributions)
Simple 401(k) plans: $13,000 (plus $3,000 in catch-up contributions)
Roth 401(k) plans: $18,500 (plus $6,000 in catch-up contributions)

(*Quick note: be sure to confirm that catch-up contributions are permitted by your company’s plan if you are planning on exercising this option.)

Benefits of 401(k) Plans

Free money

Assuming your employer offers matching contributions, you’ll have access to free money to help you increase your nest without doing any additional work on your part. Think of it as a gift from your employer or their way of saying thank you for your service to their company.

For this reason, it is highly recommended that you contribute at least up to the amount of the employer match. Otherwise, you’ll be leaving free money on the table.

Lower tax liability

The elective deferrals that you make to your 401(k) plans are on a pre-tax basis. So that means that federal income tax is deferred until you begin taking distributions. Even better, the contributions made to your 401(k) plan by your employer if they offer matching are also pre-tax. Of course, your taxable income can only be decreased to the extent of the annual contribution limits, as set forth by federal law (as discussed earlier).

The exception to the rule is the Roth 401(k) plan. But this isn’t necessarily a bad thing as you’ll be able to take distributions without having to worry about Uncle Sam taking his cut.

Facilitates saving for retirement

The beauty of 401(k) plans is the way in which contributions are made. Instead of writing a check or manually initiating a transfer, your payroll department will handle it for you. This means you won’t have to think twice about setting the funds aside because that will be taken care of before your direct deposit even hits your account. And chances are you won’t miss the money since you never hand it in your possession.

Drawbacks of 401(k) Plans

Plan Fees

In most instances, you’ll play a higher amount in administrative fees for a 401(k) than you would with a traditional IRA or other investment account. This isn’t a reason to ditch your 401(k) contributions altogether, especially if there’s an employer match. However, you may want to diversify your nest egg with other more cost-efficient investment vehicles.

Minimal Investment Options

Unfortunately, you are limited to the investment options offered by your employer’s plan. But if you set up your own brokerage account, you have the freedom to select any combination of assets that you please.

How Much Should You Contribute to Your 401(k)?

Wondering what percentage of your salary should be contributed to your 401(k)? The simple answer: up to the employer match. However, there’s no one-size-fits-all solution, and it really just depends on your financial situation and goals for retirement. Check out this guide for an in-depth look at the best way to determine how much you should be contributing to your 401(k), and what to do if you reach the annual contribution limit. (HYPERLINK)

What’s the Waiting Period Before You Can Take Distributions?

If you begin taking distributions before you reach 59 ½ years of age, you will be assessed a early withdrawal penalty of 10 percent on the portion of proceeds received. Furthermore, you will be taxed at your federal rate.

To illustrate:

Distribution Amount	Tax Bracket	Early Withdrawal Penalty	Tax Liability
$5,000	12%	$500	$600
$10,000	22%	$1,000	$2,200
$15,000	24%	$1,500	$3,600

However, the same rules do not apply to Roth IRAs. In fact, your money is accessible once it’s been in your retirement account for at least five years.

Vesting Periods

You should also know that you can only receive the funds you have a vested interest in. Any contributions you make are available for distribution, but you must be vested with the employer to receive any matching contributions made on their behalf.

Wondering what it means to be vested? In most instances, employers will require that you work for a set number of years before you become vested in their company and have access to the funds contributed. The longer you serve, the higher the percentage of vested interest you’ll have. And at some point, you’ll be 100 percent vested and have access to all the matching contributions.

Mandatory Distributions

You must start taking distributions from your retirement plan at the age of X or you’ll be subject to x (CONFIRM)

Are You Allowed to Borrow Money From Your 401(k)?

The short answer is yes, in the form of an installment loan with a low interest rate if your plan permits this practice. In most instances, payments will automatically be deducted from your paycheck each pay period. And in the event you sever employment before the loan is paid in full, the plan administrator will recoup what you owe.

Is It Mandatory to Participate In a 401(k) Plan?

While some employers automatically enroll employees in their 401(k) plan, there’s no obligation to make contributions or elective deferrals. In fact, you have the right to decide what percentage of your earnings will be deducted and allocated to your plan, if any.

What Happens to Your 401(k) Plan If the Company Shuts Down?

Worried that funds in your 401(k) plan will be dissolved if your employer ceases operations? Don’t be. In the event this does happen, you will have the option to roll your plan over into a traditional IRA without being hit with the 10 percent penalty. Furthermore, you will not be subject to federal income tax as long as you don’t take distributions.

IRA vs. 401(k): Which Is The Better Option? (see other article)

Maybe you’ve been told that an Individual Retirement Account (IRA) is a better choice than the 401(k). Or perhaps your employer doesn’t offer a 401(k), so you have to look elsewhere to build your retirement savings.

As mentioned earlier, you want to take advantage of the employer match if possible, which would make the 401(k) plan the better option to start with. Then, you can move on to your traditional IRA and sock money away there. (If a 401(k) is not an option, start with the traditional IRA and consider a Roth IRA if needed).

And if you reach the point where you max out contributions to your traditional IRA, it doesn’t hurt to return to your 401(k) and pick up contributions there. Why so? Well, your tax liability will be lower and you’ll allow the power of compounding interest to work even more in your favor. Furthermore, you’ll be building a nice cushion that could come in handy should you need to borrow money later on down the line.