What Is a 401k Plan and How Does It Work?

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401kWithout a doubt, the most well-known retirement plan is the 401k. It has been around since 1978. Believe it or not, it was originally intended as a way for banks to provide an additional retirement benefit to their employees. What they specifically wanted was a way to match a part of the contributions that employees put into their 401k accounts.

Not long after the law was enacted, other companies, beyond banks, discovered that they could offer this plan too. And so the 401k took on a life of it’s own.

Now, you might think that there’s something special about the name 401k, but there isn’t. The name just comes from the section and paragraph of the Tax Reform Act of 1978 that created this investment vehicle. Open up the Act, go to section 401, read paragraph k, and voila!

The law was written such that only employers can offer or sponsor 401k plans. So you can’t run or click over to your local broker and have them create a special 401k plan just for you.

Years after the 401k law was passed, additional acts and laws were enacted to allow other retirement plans such as 403b’s and 457’s. These plans were created to accommodate the needs of other groups such as public education, hospitals, non-profits, and religious institutions.

If you examine these plan broadly, you’ll find that they are similar to 401ks, but when you dig into the weeds you’ll uncover a few unique technical twists.

Now having said all that, I’m going to throw a monkey wrench into the mix. Recently, a new 401k kid moved into the neighborhood. This newbie goes by the name of Roth 401k. It’s a bit different from the traditional plans. You can learn more about it and which plan is better by clicking here. 

But for this article, let’s finish the discussion about the traditional 401k and similar plans.

Employer-Sponsored Retirement Plans: Benefits and Contributions

There are two big components that all traditional employer-sponsored plans have in common:

– Ability for your employer to match a portion of your contributions.
– You don’t have to pay taxes on the money you contribute to your 401k until you withdraw it.

The most common way that I’ve seen 401k’s work is that when you enroll into the plan, you’ll indicate the amount or percentage of money you want withdrawn from your pay check every two weeks or month. In addition, the company would tell you how much it will chip in to match your contributions.

For example, the company plan might state that it will pony up 50 cents for every 1 dollar you contibute to your account, up to 6% of your salary. It’s a beautiful thing. They are freely giving you money, and you should make sure that you take advantage of every matching dollar offered.

Your contributions will be automatically taken out of your pay check. I like this out of sight, out of mind approach because when you get your check, you’ll only pay attention to the net (or take home) pay amount and adjust your lifestyle accordingly.

Face it, if many people had to manually write a check every couple of weeks to contribute to their 401k plan, it probably wouldn’t happen.

Finally, another big benefit of 401ks is that you can contribute a lot of money to them. For example, in 2013 you could contribute up to $17,500 to your 401k plan. But keep in mind that this is the maximum allowed under IRS rules. Your employer could impose other limitations.

What You May Not Know About Your 401k Plan

Some employers will automatically enroll you into the company’s 401k plan on the day you start working there. They do this because they’re assuming you want to join. But they may set your starting contribution rate to a low percentage of your salary and figure you’ll raise it if you decide to save even more.

But here’s the problem. If they set your starting contribution rate to be 2% or 3% of your salary, but the plan allows them to match your contributions up to 6% of your salary, you’re losing out.

So, you need to review the plan details to confirm the employer matching amount and compare it to what’s coming out of your check. If it seems like you’re not taking full advantage of the matching, contact the human resources department and ask them to increase your 401k contribution percentage.

401k Investment Options

When you make contributions to your 401k account, you will usually choose among a variety of investment options. The most prominent options will be mutual funds.

Mutual funds generally consist of a basket of stocks (or bonds) from companies that you’d find on the stock exchanges such as the New York Stock Exchange and NASDAQ. So when you purchase a share of a mutual fund, you’ll own a small piece of each company’s stock.

What makes mutual funds so popular is that you can earn a decent return on your money without the higher risk exposure you’d have by investing in a single stock.

401k Withdrawals

First, you should only put money into your 401k that you don’t plan to withdraw prior to age 59.5. This is the minimum age where you won’t incur an additional 10% tax penalty for making a withdrawal. That percentage would be in addition to any other federal, state, and local taxes. Talk about a very painful price to pay to get your money out. So plan smartly when it comes to making contributions.

Now many people think that they can withdraw money from their 401k to pay for their education, buy a new home, or other reasons and not have to pay the tax penalty. But this is not necessarily the case. Your employer can place restrictions on your 401k withdrawals.

What To Do With 401k When Leaving Job

When you change jobs, you’re allowed to take your 401k balance with you. The best way to do this is when you talk to your new employer, just ask them about the procedures for rolling over an existing 401k account to their 401k plan. They’ll point you in the right direction and provide the forms. It’s pretty straight forward.

Now, alternatively, you can rollover the money to a Traditional or Roth IRA that you created.

The key to doing this correctly is all about timing. You’re allowed a certain window of time (usually 60 days) to perform the rollover or conversion without paying taxes. I’ve done this before and it’s not a big deal. You’ll have to fill out a couple of forms so that the IRS will know what’s going on. But your employer or IRA manager will walk you through the steps, depending on which option you choose.

401k Versus IRA

I frequently get questions from people who ask if they can have both a 401k and an IRA. The answer is yes.

Think of the 401k as a separate animal from other retirement investment vehicles. It falls on the employer side of the fence. But there is also a non-employer side of the fence where you’ll find retirement investment vehicles such as Traditional and Roth IRAs.

Each side of the fence has it rules and maximum contribution limits. I covered the 401k contribution limit earlier. But when you cross over to the non-employer side, you’ll discover that you can contribute up to $5,500 to an IRA in 2013 (and $6,500 if you’re age 50 or older).

Finally, you can have as many Roth and Traditional IRAs as you like as long as your total contribution amount doesn’t exceed the max limit for one IRA.

401k Contribution Strategy

A 401k plan ( and the other similar employer retirement plans) is probably the best retirement saving vehicle available. So you should definitely participate in one. Here are some specific suggestions:

  • First determine how much (or percentage) of your annual salary will be set aside for all of your saving and investing accounts, even beyond your 401k. The general rule of thumb is 10%-15% of your salary.
  • At a minimum, contribute enough money to cover all your employer’s 401k matching dollars.
  • Whatever you contribute to your 401k, plan on kissing it goodbye until you reach age 59.5.
  • Determine how much money you’ll need to save for a future home, car, furniture, etc. Put this money in other investments where you can withdraw it any time without the fear of being charged a tax penalty. For example, you can open a regular investment account at a brokerage firm and invest in mutual funds.
  • Contribute to your 401k on a regular and consistent basis.
  • Compare the Traditional 401k discussed above with the Roth 401k covered here, and choose the one that works best for you.

So now you know what a 401k plan is and how it works. There shouldn’t be any doubt regarding whether or not you should participate in it if your company offers such a plan. And take advantage of all the matching dollars that the company is willing to put in. If you make steady contributions, you’ll find that by the time you reach retirement age you’ll have enough money to live quite comfortably.