How Does a 401(k) Plan Work?

Updated on 05/24/2022

How Does a 401(k) Plan Work?

If you are planning your retirement, you may be wondering, “What is a 401k plan?” A 401k helps you save for retirement. While most Americans qualify for Social Security benefits, these benefits are only meant to supplement a portion of a retiree’s income. Having a 401k plan will help you maintain your lifestyle after you retire.

If you’re wondering, “How does a 401k plan work?” You’re not alone. Many Americans ask the same question as they begin to think about retirement.

A 401k plan is a special account that you contribute funds into from your paycheck until you retire. Many companies offer these plans as part of their employee benefits. When offered and selected, your contribution is automatically deducted from your paycheck and your employer puts the funds you contribute into the account, according to the rules of the plan and your directions. This investment can grow throughout your career.

The money you put into 401ks is typically not taxed. Instead, you pay taxes on this money when you withdraw the funds from the account.

Learn About the Best 401k Plans

To better understand the question, “How does 401k work?” it’s essential that you learn more about the most common types of plans. Each plan has a few differences.

Traditional 401k Retirement Plans

Traditional 401k retirement plans are commonly offered by companies that provide retirement benefits. Like many 401ks, the funds that you contribute will not be taxed until they are withdrawn from the account.

With traditional plans, some employers may match an employee’s contribution up to a specified amount. These plans allow contributions up to the fixed annual limit. In 2022, that limit is currently $20,500, and that includes both employee and employer contributions.

One drawback of these plans is that funds deposited into an employee’s account on behalf of the company only become non-forfeitable after a specified period of time. Basically, if an employee leaves a company before that period, they may lose employer-sponsored contributions to their account.

Traditional plans will also require your employer to perform an Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) test annually. These tests are provided by the IRS and ensure that plans offered by your employer are non-discriminatory.

Safe Harbor 401k Plans

Unlike traditional 401ks, employers are not required to pass an annual ADP and ACP test if they offer a safe harbor plan. That makes them popular among small businesses because employers normally have to pay for these tests. Instead, with a safe harbor 401k, your employer is required to contribute to your 401k account. Like a traditional 401k, annual limits to the amount that you and your employer can contribute still apply.

Unlike traditional plans though, money that an employer contributes to your account becomes yours immediately rather than over a period of time. This can be beneficial as it means you will keep these contributions even if you leave the company and regardless of when you may decide to leave it.

SIMPLE 401k Plans

A SIMPLE 401k retirement plan is also commonly found through small businesses. Additionally, self-employed professionals can take advantage of 401k benefits through SIMPLE plans. While SIMPLE plans contain many of the benefits and features of a traditional 401k, your employer will be required to contribute to your account, and that money must become yours right away. However, these plans are only available through employers that have 100 or fewer employees.

Another significant difference between traditional 401k retirement plans and SIMPLE plans is the contribution limit. The contribution limit for a SIMPLE plan is $14,000 as of 2022.

What Happens to Your 401k When You Quit?

This is another commonly asked question when it comes to 401ks. If you have a 401k account with an employer and you decide to leave that employer, you will have three options available:

  • Withdraw your funds early. You can always choose to withdraw your funds. However, if you are under the age of 59 and a half years old, you will likely pay a penalty for doing so. Additionally, the money will be taxed.
  • Move your funds to an IRA. You can avoid paying a penalty or taxes by moving your account funds to an individual retirement account (IRA) through a management company.
  • Move your funds to a new employer. If your new employer offers a 401k plan, you can move your funds to the new account. However, some plans cannot be transferred to a new account, so be sure to ask your new employer about this as soon as possible.

How to Get the Most Out of Your 401k

There are several ways that you can maximize your 401k benefits. Here are some tips to consider:

  • Starting a 401k with an employer that offers a high matching contribution
  • Investing early and investing at the highest rate possible
  • Avoiding investments that include fees and charges that eat away at your contributions
  • At a minimum, investing up to the maximum amount that your employer will match to maximize your total 401k contributions
  • Not taking money out of your account once you begin to invest, so that you avoid heavy fees/taxes
  • Choosing the right 401k plan for you, as some have riskier and safer strategies depending on your preference
  • If you are 50 or older and you are behind on your savings, using the catch-up provision to your advantage

Understanding 401k Catch-Up Provisions

If you didn’t start a 401k plan until later in life, you can take advantage of catch-up provisions at the end of the calendar year when you are at least 50 years old. Catch-up provisions allow you to electively defer additional portions of your salary towards your 401k account beyond the limit of your plan.

With the catch-up provision, you can contribute an additional $6,500 to traditional and safe harbor 401k plans as of 2022. For SIMPLE 401ks, the additional amount that you can contribute is set at $3,000 as of 2022.

While this provision is commonly used when a worker is “behind” on saving for retirement, anyone who is at least 50 years old can contribute additional funds to their retirement account.