What is a 401(k) Plan?

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A 401(k) plan is a tax-advantaged, employer-sponsored retirement savings account designed to help employees in the United States save for retirement. It allows employees to contribute a portion of their pre-tax salary to the account, where it is invested in various financial assets such as stocks, bonds, or mutual funds. These contributions grow tax-deferred until withdrawal at retirement.

Employers often encourage participation by offering a matching contribution, where they match the employee’s contributions up to a certain percentage of their salary.

For employees in the United States, a 401(k) plan can be one of the most powerful tools for building retirement wealth. With the advantages of tax savings, employer matching, and compound growth, these plans offer a structured and highly beneficial way to save for retirement. By starting early, contributing consistently, and taking full advantage of employer matching, individuals can significantly boost their retirement savings and ensure long-term financial security.

Note: If you, as an employee, want to contribute post-tax salary instead of pre-tax salary, you need to use a Roth 401(k) instead of the classic 401(k). Choosing between a Roth 401(k) and a traditional 401(k) depends on your current and expected future tax bracket. If you anticipate being in a higher tax bracket during retirement, a Roth 401(k) might be more beneficial because your withdrawals will be tax-free. On the other hand, if you expect to be in a lower tax bracket in retirement, a traditional 401(k) could save you more in taxes now.

How Does a 401(k) Work?

Understanding the Background

Prior to 1974, it was possible for employers in the U.S. to give their employees the option to receive cash instead of employer-paid contributions to a tax-qualified retirement plan account. In 1974, the U.S. Congress banned this practise and launched a study. When the study had been completed, Congress removed the ban – but also instituted limitations. Contributing cash was now permitted, but only if it went into a retirement plan that fulfilled certain requirements. This was specified in Internal Revenue Code Section 401(k) as part of the Revenue Act of 1978.

401(k) Fees

Having a 401(k) plan is not free of charge. The plan will charge fees for tasks such as:

Investment management services
Administrative services
Record-keeping services
Outside consulting services

The fees can the charged to the plan participant (the employee), the employer, or money can be taken from the plan itself.

Fees can be allocated on a per participant basis, a per plan basis, or a as a percentage of the plan´s total assets.

In 2015, the U.S. Supreme Court ruled that plan administrators could be sued for excessive plan fees. For more information, see Tibble v. Edison International.

Types of 401(k) Accounts

There are two main types of 401(k) accounts: Traditional 401(k) and Roth 401(k).

1. Traditional 401(k)

In a traditional 401(k), contributions are made pre-tax, meaning they reduce your taxable income in the year of the contribution. The money grows tax-deferred, meaning you don’t pay taxes on the investment gains until you withdraw the money during retirement. At withdrawal, distributions are taxed as ordinary income.

Pros: Immediate tax savings, growth potential through tax deferral.
Cons: Taxes on withdrawals, required minimum distributions (RMDs) starting at age 73.

The 401(k) plan is named after subsection 401(k) of the U.S. Internal Revenue Code, which is the subsection where this type of plan is defined.

2. Roth 401(k)

A Roth 401(k) differs from the traditional account in that contributions are made with after-tax dollars. However, your investments grow tax-free, and withdrawals during retirement are also tax-free (as long as you’re over 59½ and have held the account for at least five years). This is ideal for individuals who anticipate being in a higher tax bracket during retirement.

Pros: Tax-free withdrawals, tax-free growth.
Cons: No immediate tax break, RMDs apply starting at age 73 (unless rolled into a Roth IRA).

The Roth 401(k) retirement plan provision has been available since 2006. It is called Roth 401(k) due to similarities with the Roth IRA, which became available in 1998. The Roth IRA is named after U.S. Senator William Roth, who championed the Roth IRA.

Tax Advantages of 401(k) Plans

401(k) plans offer significant tax benefits:

Traditional 401(k): Contributions are pre-tax, lowering taxable income in the year of contribution. Taxes are deferred until withdrawal, allowing the account to grow tax-free over the years.
Roth 401(k): Contributions are after-tax, meaning there’s no immediate tax break, but withdrawals in retirement are tax-free, as is the growth in the account.

These tax advantages help individuals accumulate more wealth over time, as the money that would have gone to taxes can remain invested.

Employer Matching

One of the biggest benefits of a 401(k) plan is the employer match, when applicable. Many (but not all) employers match employee contributions up to a certain percentage of the employee’s salary. For example, if an employer offers a 50% match on up to 6% of salary, an employee earning $60,000 who contributes 6% ($3,600) would receive an additional $1,800 from the employer, boosting their retirement savings by a considerable amount.

Withdrawal Rules and Penalties

There are strict rules around withdrawing funds from a 401(k):

Early withdrawals: If you withdraw funds before age 59½, you withouth an accepted exception, you will face a 10% early withdrawal penalty in addition to paying income tax on the withdrawn amount. Hardship withdrawals or qualifying for a disability are examples of accepted exceptions, but there are requirements that must be fulfilled for each exception to be eligiable.
Required Minimum Distributions (RMDs): Starting at age 73, you must begin taking Required Minimum Distributions (RMDs) from a traditional 401(k), meaning you are required to withdraw a minimum amount each year, and these withdrawals are taxed as income. Failure to take the required withdrawals results in severe tax penalties.
Roth 401(k) withdrawals: With a Roth 401(k), withdrawals are tax-free as long as the account has been held for at least five years and you are over age 59½. Early withdrawals are subject to the same penalty rules as traditional accounts but only on the earnings, not the contributions.

Investment Options

401(k) plans typically offer a range of investment options, including:

Stocks (equities): These provide growth potential but carry more risk.
Bonds (fixed income): Offer stability and income but tend to have lower returns.
Mutual Funds/ETFs: Professionally managed portfolios that diversify investments across multiple assets, but can come with high fees.

Most 401(k) plans allow participants to adjust their investment portfolio according to their risk tolerance and retirement goals.

Borrwoing From Your 401(k)

Some 401(k) plans offer a loan option, allowing employees to borrow from their account balance without facing tax penalties, as long as the loan is repaid with interest and certain requirements are fulfilled. Loans must generally be repaid within five years, and the amount you can borrow is capped at either $50,000 or 50% of your vested account balance, whichever is lower.

However, borrowing from your 401(k) will of course reduce the amount of money available for investment, slowing the growth of your retirement fund. Borrowing from your 401(k) is a decision that should not be taken lightly.

Rollovers

In certain circumstances, it is possible to rollover assets from one eligible retirement plan to another. It takes place in one of two ways:

By a direct rollover from one plan to another plan.
By a distribution to the participant and a subsequent rollover to another plan. In most situation, the rollover to the other plan must be carried out within 60 days of the distribution to be considered a rollover. If the rollver does not happen within this time frame, no rollover can take place, the entire distributed amount will be taxed as income, and – if applicable – the 10% penalty will be applied.

Can I convert a traditional 401(k) to a Roth 401(k)?

Yes, since 2013, the IRS have permitted the conversion of a traditional 401(k) to a Roth 401(k). It can only happen if the employee’s company plan offers both a traditional 401(k) and a Roth 401(k), and the plan explicitly allows conversions.

Rollovers as business start-ups (ROBS)

During certain circumstances, a prospective business owner can be allowed to use their 401(k) retirement funds to pay for start-up costs when they establish a business that is a corporation. This is called ROBS. The individual will be permitted to roll over their existing retirement 401(k) to a ROBS plan in a tax-free transaction. The ROBS plan will then use the assets to purchase the stock of the new corporation.

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