Is a 401(k) a Retirement Plan? How It Works
Discover how a 401(k) plan is structured for retirement, from how money is contributed to the tax principles that support long-term financial growth.
A 401(k) plan is a retirement savings vehicle offered by many employers, named after the section of the Internal Revenue Code that governs its operation. These plans provide a structured way for employees to save a portion of their income for retirement. The funds are held in a trust for the benefit of plan participants and their beneficiaries.
How a 401(k) Works
A 401(k) works through automatic payroll deductions. An employee decides what percentage of their salary to contribute, and the employer deducts this amount from each paycheck to deposit into the retirement account. The funds are then invested in options selected by the employee from a menu provided by the plan.
Many employers offer a matching contribution. For example, an employer might match 50% of what an employee contributes, up to the first 6% of their salary. If an employee earning $60,000 a year contributes 6% ($3,600), their employer would add an additional $1,800, boosting their total savings.
Employees have a choice between two types of contributions: traditional and Roth. With a traditional 401(k), contributions are made on a pre-tax basis, which lowers your current taxable income. If you earn $80,000 and contribute $5,000, you will only be taxed on $75,000 for that year. Roth 401(k) contributions are made with after-tax dollars, so qualified withdrawals in retirement are tax-free.
Core Features of a 401(k) Plan
A 401(k) has tax-advantaged status where investments experience tax-deferred growth. This means you do not pay taxes on investment earnings, such as dividends or capital gains, each year, allowing the account to compound more rapidly. Taxes are paid when you withdraw the money in retirement, unless it is from a Roth account.
Funds are meant to be left untouched until retirement age. If you withdraw money from your 401(k) before reaching age 59 ½, you will face a 10% early withdrawal penalty on top of regular income taxes.
An exception to this penalty is the “Rule of 55,” which allows an individual who leaves their job in the year they turn 55 or older to take distributions without the penalty. Vesting determines when you have full ownership of your employer’s matching contributions. Your own contributions are always 100% yours, but employer funds may require you to work for a certain period before they are fully vested.