What is a 401k and How Does It Work?

A 401k is an employer sponsored retirement plan. Many investors take advantage of their employer's 401k plan if one is offered. The account offers several tax benefits, and most employers will match your contributions up to a percentage of your total compensation.

When you enroll in your company's 401k plan, a percentage of your paycheck is automatically taken out and put in your 401k by your employer. The money inside your 401k is invested in a small selection of mutual funds offered by your plan. You get to select what funds to hold inside of your 401k.

The contributions that you make to your 401k are made with pre tax dollars (dollars that have not been taxed by the IRS yet) and are tax deductible. For example, if you make $80,000 per year and contribute $5,000 per year to your 401k, your taxable income would be lowered from $80,000 to $75,000. The $5,000 that you contributed would have come out of your paycheck before taxes were taken out.

Additionally, 401(k)s offer a tax deferred benefit. Over time, the investment funds that you hold within your 401k are going to increase in value. If you were to hold these investment funds within a taxable brokerage account, you could incur capital gains tax if you decided to sell the funds for a profit.

However, a 401k allows you to defer all of the gains you make from investments until you pull the money out in retirement. Essentially, you get to wait to pay taxes until you retire. There is a caveat to this, but we will look at that when we go over the rules of the account.

Finally, most employers will match your contributions up to a set amount of your compensation. For example, lets say that your employer offers a 401k plan with a 4% match. If you make $100,000, you could contribute $4,000 to your 401k and your employer would match your contributions with another $4,000 (4% of your compensation).

The way that 401k matches work can vary, so it is important to understand how your specific employer match works. It is also important to understand that some employers have what is called a vesting schedule for matching contributions.

A vesting schedule simply dictates how long it takes before your employer's matching contributions are 100% yours. For example, your employer might have a vesting schedule of 2 years. This means that you would have to work at the company for at least 2 years before your employer's matching contributions are 100% yours.

If you were to leave the company before 2 years, you might only be entitled to a partial amount of your employer's matching contributions or no amount at all. It is important to understand your company 401k vesting schedule as it can sometimes take years before your employer's matching contributions are 100% yours.

Keep in mind that a vesting schedule only relates to your employer's matching contributions. The contributions that you make to your 401k plan yourself are always 100% yours.

There are several types of 401(k)s available. However to keep things simple, we will look at the main two - the Traditional and Roth 401k. If your employer offers a 401k plan, it is most likely a Traditional 401k, but many employers are also starting to offer a Roth 401k as well.

When you hear someone discussing a 401k, they are usually talking about a Traditional 401k. The Traditional 401k is what we covered above. It allows you to defer paying taxes until you retire, get a tax deduction on your contributions, and potentially get your employer to match a percentage of your contributions.

The Roth 401k works in the opposite way of a Traditional 401k. When you contribute to a Roth 401k, you contribute using post tax dollars. Essentially, the dollars that you put into a Roth 401k have already been taxed, where as the dollars you put into a Traditional 401k have not been taxed yet.

However, since you have already paid taxes on the dollars you contribute, the contributions grow tax free and you do not have to pay any taxes when you pull the money out of the account in retirement. Unlike a Traditional 401k, contributions made to a Roth 401k are not tax deductible. In other words, you do not get an immediate tax benefit on the dollars or you contribute to a Roth 401k.

However, you do get major tax benefits when you retire. In some cases, it can make more sense to pay taxes today, but then enjoy tax free withdrawals from a Roth 401k when you retire. Employers will typically offer to match your contributions to a Roth 401k just like they would on a Traditional 401k.  

A 401k does not make you money itself. It is simply an account that holds investments. It is the investments within a 401k that will make you money. So, you might be asking yourself what you can invest in through a 401k?

It depends upon your company's specific plan, but in general most 401k plans offer a small selection of mutual funds. A mutual fund pools money from many investors and uses that money to buy lots of assets all at once, such as stocks and bonds.

In other words, you do not have to choose individual stocks when you invest through a 401k. You can simply select a few mutual funds from your specific plan that you would like to invest in. Your plan might offer mutual funds that invest in Large Cap US Stocks, Small Cap US Stocks, and International or Emerging Market Stocks.

Some financial experts recommend allocating your 401k investments across several mutual funds offered by your plan. If you need help choosing investments for your 401k, it is a good idea to speak with a financial advisor.

Lets return to the original question - how do you make money with a 401k? It's simple. Once you have chosen several mutual funds to invest in, you simply need to make consistent contributions to the account and wait. As the investments within your 401k grow, you will make money over time.

It should also be noted that your employer match is another way that you can make money with a 401k. Keep in mind that not all employers offer a match. You also need to understand the vesting schedule for your specific plan to make sure that you are able to take 100% of your employer's match.

The 401k, both the Roth and the Traditional, has several rules that you must follow when using the account. It is important to understand these rules so that you can use the account properly if you decide to do so.  

Due to the tax benefits that a 401k offers, the amount that you can contribute to the account is limited. For 2024, you can contribute up to $23,000 per year or $30,500 per year if you are 50 or older. These are just the contributions that you are allowed to make. With an employer match, the amount you could invest each year could be higher.

For example, lets say that you are 40 years old and are in the position to make that maximum contribution of $23,000. Lets say that your employer is going to contribute an additional $5,000, which would bring your total contributions for the year to $28,000.

In general, you are not allowed to pull any of the money out of a 401k until you are at least 59 and a half years old. If you try to access the money in the account before then, you can incur a 10% penalty on the amount you withdrew, as well as any applicable income taxes.

There are exceptions to this rule, but most financial experts do not recommend pulling money from your 401k until you reach retirement. We should also note that for a Roth 401k, the account needs to be at least 5 years old before you can make penalty free withdrawals.

Required minimum distributions (RMDs) are the minimum amount you must pull out from a 401k once you reach a certain age. In other words, the IRS forces you to pull money out the account. However, starting in 2024, RMDs do not apply to Roth 401(k)s thanks to the passing of the Secure Act 2.0.

RMDs are still in effect for Traditional 401(k)s. You have to take RMDs for Traditional 401(k)s once you are 73 years old. Your RMD is determined by dividing your account balance by your remaining life expectancy. When you take an RMD from a Traditional 401k, you will have to pay income taxes on the withdrawal since you deferred the taxes until retirement.  

Since you have not paid taxes on the dollars that you contributed to a Traditional 401k, the IRS forces you to pull money out of the account so that they can tax those dollars. If you miss an RMD, you can incur a 25% penalty if you don't correct the missed RMD on time.

1) Employer match - The biggest benefit of a 401k is arguably your employer's match. If you take advantage of the full match, you can boost the amount you are able to invest by thousands of dollars per year. You have probably heard some people say that a 401k match is "free money".

While we understand the sentiment, remember that your employer might have a vesting schedule which could mean that this "free money" won't actually be yours for years.

2) Tax benefits - Both the Traditional and Roth 401k offer good tax benefits. You either get to defer your tax bill by making tax deductible contributions, or you get to have tax free growth and tax free withdrawals in retirement.

3) High contribution limits - When compared to other tax advantaged investing accounts, 401(k)s have high contribution limits. If you are in the position to do so, you can invest large sums of money into a 401k and still get tax benefits.

4) Easy to use - Many investors like 401(k)s as they are fairly easy to use. You simply set the account up with your employer, select your investments, and a portion of your paycheck is automatically invested each month so you don't have to lift a finger.

1) Limited investment options -  A 401k does not offer a broad selection of investments. You are stuck with the small selection of investments that your specific plan offers. If you want more control over what you invest in, it is better to invest using a different type of investing account.

2) Lack of accessibility - You are not allowed to access the funds within your 401k until you are at least 59 and a half years old - unless you want to pay a 10% penalty. Now, the point of a 401k is to save for your retirement so some investors don't mind this.

However, if you place all of your available dollars into a 401k, you can run into trouble when you need access to money during the course of your life. This doesn't mean that using a 401k is a bad idea. It simply means it might be better to spread your available dollars across more financial accounts than just a 401k.

3) Lack of control - Since a 401k is an employer sponsored retirement plan, you do not have total control over the account. First, you could be an employee at a company that does not offer a 401k plan. You could also leave a company that does have a 401k plan, for a company that does not.

Secondly, your employer gets to decide what investments the plan holds and how much to match your contributions, if at all. Although a 401k does offer some good benefits, it might not be a good idea to base your entire retirement plan off of it due to the lack of control you have over the account.  

You do not have to rely solely on a 401k to save for your retirement. For the every day investor, there are also IRAs. An IRA is an individual retirement account. The account is not a workplace retirement plan. It is a retirement account that you can hold outside of work through online brokers or robo advisors.

Similar to 401(k)s, IRAs offer both a Traditional and Roth IRA with similar tax benefits. The Traditional IRA allows you to defer taxes until retirement and offers the potential for a tax break today depending upon several factors. The Roth IRA allows your money to grow tax free and allows you to make tax free withdrawals in retirement.

An IRA will give you more control over the account itself and the investments that you can hold in the account. You can invest in a much larger selection of assets in an IRA than you can in a 401k. Additionally, an IRA will follow you no matter where you work, where as a 401k has to be offered by your company in order for you to participate.

Using an IRA in tandem with a 401k is a strategy that some financial experts recommend. However, figuring out how much to contribute to each account, whether to use a Roth or Traditional version, and what to invest in through the account can become complicated. Speaking with a financial advisor for guidance on these issues is always a good idea.  

The short answer is that it depends. In general, you will probably hear something along these lines. "You should invest enough in your 401k to get your employer's full match." This is probably a good place to start for most people.

The 401k does offer some good benefits and for most every day investors, it can be a good idea to take advantage of them. With that being said, the more money you allocate towards your 401k, the less you will have to allocate to other financial accounts, areas, and investments.

For example, lets say you were in the position to make the maximum contribution of $23,000 to your 401k. If you did make the maximum contribution to your 401k, all of your investments would be tied up in a single account. You would get some benefits by doing this, but you would also be restricted.

Instead, you could contribute enough to your 401k to get your employers full matching contribution and then allocate the remaining dollars to other areas. Lets say that in order to get your employers math, you would need to contribute $8,000 per year.

You would be left with $15,000 of available dollars to invest after investing in your 401k. You could use this money to invest through an IRA, invest in real estate, invest in your own education to increase your earning capacity, and much more.

The point here is that the 401k does offer some benefits that you might want to take advantage of. However, the account does have some drawbacks. The idea here is to take advantage of the benefits that the 401k has, and allocate any remaining dollars you have to other places that don't have the drawbacks of a 401k.

At the end of the day, creating a financial plan that is right for you can be challenging. We always recommend speaking with a financial advisor to help you make financial decisions - including whether or not to use a 401k.

A 401k is an employer sponsored retirement plan. The Traditional 401k allows you to deduct contributions you make today, and defer paying taxes until you retire. The Roth 401k does not allow you to deduct the contributions that you make, but your money grows tax free and withdrawals in retirement are tax free.

The 401k can provide several benefits including an employer match, tax benefits, and high contribution limits. However, a 401k limits your investment options, does not allow you to access the funds in the account before a certain point, and restricts the control you have over the account.

Using a 401k may be a good option for you depending upon your individual circumstances. Some financial experts recommend investing enough in your 401k to get your employer's match. However, the more you invest in your 401k, the less money you will have to deploy elsewhere.

It might be a good idea to put some of your dollars towards your 401k, but allocate other available dollars to other areas such as an IRA. Keep in mind that figuring all of this out can be tricky, which is why it is a good idea to speak with a financial advisor.