If you work full-time and aren’t self-employed, there is a good chance that you have access to a 401(k) plan. There is also a good chance that you don’t understand the plan well.
A 401(k) plan is a powerful tool for building wealth. Understanding it will help you make informed decisions about using this tool in your wealth-building efforts.
In this article, I’ll teach you the basics. I’ll use plain language as well as outline potential steps you can take to make the most of this benefit.
What is a 401(k)?
A 401(k) is a retirement savings plan sponsored and administered by your employer. The name of this type of retirement savings plan comes from the section of the Internal Revenue Code that created it: Internal Revenue Code section 401(k).
How does a 401(k) plan work?
Employers offer 401(k) plans to their employees with the specific intent of helping them to save and build wealth. 401(k) plans offer contribution matches and profit-sharing features that can attract and retain talent and give employees a chance to share in company profits. While participation is smart, but it is not mandatory. There are three ways money can get into the plan:
Each employee can defer a portion of their salary right from their paycheck, up to the IRS limit, on a pre-tax basis. This means that any amounts you put into the plan are not subject to income tax in the year the money is earned and deferred.
For 2023, an individual may defer up to $22,500 (plus another $7,500 if they are 50 or older) on a pre-tax basis.
“Contributing to a 401(k) can lower your tax bill.”
This can lower your overall tax bill and may even bump you down into a lower marginal tax bracket depending on how the math shakes out.
Employers are not always required to offer a match on employee contributions, but many do. There are a handful of different matching formulas, but the most common one is for the employer to match, dollar for dollar, the contributions you make that equal as little as 3%, or as much as 6%, of your compensation.
For example, if your salary is $100,000 a year and you defer $4,000 into the plan and your employer matches up to 3%, you would receive a match of $3,000 (3% of your annual salary). If you contributed only $2,000 – or 2% of your salary, your employer would match only $2,000. Setting your salary deferral to capture the full employer match is a popular strategy for many.
Some 401(k) plans also have a Profit Sharing Plan attached. This allows your employer to share a portion of the business’ profits with you and other employees. There are a few ways to compute each employee’s share of profits. Typically, it’s tied to your salary, so the more you earn in salary, the higher your profit-sharing contributions could be.
“A Profit Sharing contribution is like icing on the cake.”
One important thing to be aware of is that profit share contributions are extremely flexible. You may receive a large contribution one year and none the next.
Tip: Think of profit share contributions as potential icing on the cake of a sound 401(k) contribution strategy.
What about investments?
Most 401(k) plans include a default investment for all participants. The default investment is often a vehicle called a “Lifecycle” or “Balanced” fund. Regardless of what it is, know that the default investments must be chosen with a fiduciary standard of care by the plan sponsor (that’s your employer).
A Lifecycle fund is an investment that owns a well-diversified collection of assets like stock, bonds, and cash. These funds are designed to be riskier when you are younger and become less risky as you approach retirement.
A Balanced fund is an investment that owns a well-diversified collection of assets like stocks, bonds, and cash. These funds are designed to be moderate in terms of risk and remain at the same level of risk over time.
If you don’t feel comfortable choosing your own investments, the default option in your plan is designed to be foolproof and is likely suitable for you to own. Your plan administrator should have information on investment choices within the plan.
You can also choose your own investments from a menu provided within the plan. Unlike an investing account or IRA, you can’t purchase just any investment you wish; only the investments that are offered through the 401(k) plan. To ensure savers like you will have quality investment choices, the funds within the plan must be assessed for their suitability and chosen with a fiduciary standard of care.
What’s in it for me?
Great question! I am glad you asked.
Most of the wealth-building benefits for you have to do with taxes.
Because the government’s primary tool for incentivizing behaviors, like saving for retirement, is the tax code.
Tax Goodies Today
When you defer your salary into your 401(k), you avoid paying income tax on those dollars. When your employer matches contributions, you also avoid paying income taxes on those dollars. When your employer makes a profit share contribution, you avoid paying income taxes on those dollars as well. That can add up quickly.
Tax Goodies Over Time
Your 401(k) money lives inside a tax-deferred wrapper. That means that if your investments grow in value, you won’t be taxed immediately. Taxation is deferred until you take money out of the account.
If you aren’t paying taxes on those dollars year after year, that’s more dollars that remain invested and growing inside your 401(k). As a rule of thumb, an investment that earns 7% annually will double every 10 years. The more dollars in your 401(k) plan, the more dollars that benefit from compounding. Compounding tax-deferred returns are a benefit that adds up nicely over time.
“Compounding tax-deferred returns are a benefit that adds up nicely over time.”
Tax Goodies End Eventually
Under the current tax law, when the plan participant (that’s you) attains age 72 (note- this changed with Secure Act 2.0), they must begin taking Required Minimum Distributions (RMDs). This simply means you have to start taking money out of the account, which is a taxable event. Think of it as Uncle Sam’s way of taking his pound of flesh after all those years of tax deferral.
Your RMD is calculated annually based on the account balance on December 31st of the prior year. The balance is then divided by a life expectancy factor. This is designed to draw down the account over your remaining lifetime.
401k Frequently Asked Questions
A few questions come up pretty frequently, and I’ll address those here.
Should I, can I, contribute more than the IRS limit?
First of all, many people struggle to maximize their 401(k) contribution, so I’d focus on that goal first. But yes, you can contribute more than the IRS limit to your 401(k) plan each year if you wish to. However, any amount over the IRS limits will be subject to income tax, so you’ll miss out on part of the tax benefits outlined above for those amounts.
If you’re making a maximum 401(k) contribution, an IRA or non-retirement investing account is a good next option. Having long-term money that you can access with no penalties may be an important element in your financial plan.
When can I start taking money out of my 401(k)?
You can typically begin to take distributions when you attain age 59 ½. You’ll pay income tax on those withdrawals.
What if I need the money in my 401(k) before I retire?
Generally speaking, 401(k)s are designed as long-term retirement savings vehicles. But there are ways to access balances under certain circumstances.
Some plans permit participants to take loans against their 401(k) balances. The loan proceeds are not taxable and do not trigger an early distribution penalty. Those loans need to be paid back over time; otherwise, your loan could be re-characterized as a distribution that would trigger taxes and an early distribution penalty.
The law also permits hardship withdrawals for things like medical bills, a home down payment, college tuition for yourself, your spouse, or dependents, funds to avoid foreclosure on a primary residence, and the cost of certain repairs to a primary residence. In these cases, you’ll need to pay taxes on the distribution, but you’ll pay no penalty.
There are a handful of other circumstances when 401(k) funds can be accessed before age 59 ½, but the ones above are the most widely relevant. If you wish to access funds from your 401(k) before you attain age 59 ½, work with your 401(k) plan sponsor to learn about your options.
What do I do with an old employer's 401(k)?
You have four options for an old 401(k).
- Leave the account where it is.
This is the easiest option, but it could leave you with many old accounts floating around in many different places. Having assets at multiple institutions can make managing your overall portfolio harder.
- Distribute the entire balance in cash.
In my opinion, this is almost never a great option. You’ll typically trigger income taxes as well as early distribution penalties and lose future tax deferral on the balances withdrawn.
- Roll the plan assets over to your new employer’s 401(k).
This is not always well-known by 401(k) plan participants. Not every 401(k) plan accepts incoming rollovers, so you’ll need to check with your new employer to see if this is an option. This option, if available, can help you keep your funds consolidated, take advantage of lower-cost investment choices, and avoid the need to track multiple accounts across multiple institutions. There are also credit-protection reasons for leaving the assets in a 401(k).
- Roll over to a Rollover IRA.
This is one of the most well-known and popular options. Most brokerages will allow you to open and fund a Rollover IRA with assets from a 401(k) plan held through a prior employer. Be sure to look at the fees you’ll pay when you rollover. You may end up paying more in fees than you would if you rolled the balance over to your new employer's 401(k) or left it in place with your old employer.
My 401(k) statement shows an account balance and a vested balance. What gives?
Some employers attached a vesting schedule to their matching and profit share contributions.
The funds you put into your 401(k) through salary deferrals are always 100% vested, but the funds your employer puts into your 401(k) may vest over a period of time. Any balances that are not vested don’t yet belong to you and could be forfeited if you leave that employer.
When considering how to use your 401(k), I suggest you consider a “Good, Better, Best” approach.
Good: Contribute something, anything, as long as you are contributing. It could be as little as $20 a month when you are first starting out. If you are young, time is your best friend because compounding is more powerful over long periods of time. Start saving early!
Better: Contribute enough the capture the match your employer offers. For example, if your employer offers a dollar-for-dollar match on contributions up to 3% of your compensation, you should aim to contribute 3% of your salary.
Best: Contribute up to the IRS-defined pre-tax limit. For 2023 that is $22,500 plus an additional $7,500 catch-up contributions if you are age 50 or older.
If you’re already making a maximum 401(k) contribution, you may wish to consider opening and funding an IRA next. But that isn’t the right next step for everyone.
Lean more: How much should I be saving? And where?
A competent Financial Planner can look at your goals, needs, and resources to guide you on what to do next on your wealth-building journey.
Ready to get started? Click here to schedule your free one-hour consultation.
Fact-checking for this article was graciously provided by Bard Bartick, CFP®, CWS®, Wealth Planner in the Wealth Solutions Group at Robert W. Baird & Co Inc.
 These limits are adjusted periodically, and you should check annually to see what the limit is.
 These deferrals are still subject to employment taxes like Social Security and Medicare.
 Making salary deferrals into a 401(k) plan lowers your taxable income in the year the deferral is made.
 Assets held in a 401(k) are shielded from creditors while assets held in IRAs are not.
 Subject to the limitations of your employer’s plan. Some may have a minimum contribution threshold.