401(K)

By:

Arti

Arti is a specialized AI Financial Assistant at Invezz, created to support the editorial team. He leverages both AI and the Invezz.com knowledge base, understands over 100,000... read more.

Reviewed by:

Prash Raval

Prash is a financial writer for Invezz covering FX, the stock market and investing. For over a decade he has traded spot FX full time while... read more.

Updated:  May 28, 2024

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3 min read

3 key takeaways

• A 401(k) plan helps employees save for retirement with tax advantages.
• Contributions are made pre-tax, and investment growth is tax-deferred.
• Employers often match a portion of employee contributions, boosting savings.

What is a 401(k)?

A 401(k) is a retirement savings plan offered by many American employers that has tax advantages for the saver. It is named after a section of the U.S. Internal Revenue Code. Employees can contribute a portion of their wages to their 401(k) account, and in many cases, employers will also make contributions, often matching the amount the employee contributes up to a certain percentage.

The money in a 401(k) account is invested in a variety of assets, such as stocks, bonds, and mutual funds, allowing it to grow over time. Contributions are made pre-tax, meaning they are deducted from an employee’s paycheck before income taxes are applied. This can lower the individual’s taxable income, providing immediate tax benefits. The funds in the account grow tax-deferred, meaning taxes on investment gains are not paid until the money is withdrawn, typically after retirement.

Types of 401(k) plans

There are different types of 401(k) plans available:

• Traditional 401(k): Contributions are made with pre-tax dollars, reducing taxable income for the year the contributions are made. Taxes are paid upon withdrawal.
• Roth 401(k): Contributions are made with after-tax dollars, meaning there is no tax deduction when contributions are made, but withdrawals are tax-free if certain conditions are met.

Benefits of a 401(k)

• Tax advantages: Contributions reduce taxable income in the year they are made, and investment growth is tax-deferred.
• Employer match: Many employers match a portion of employee contributions, providing additional funds for retirement at no extra cost to the employee.
• Compounding growth: Investments in a 401(k) can grow over time through the power of compounding, significantly increasing the retirement savings.
• Automatic payroll deductions: Contributions are automatically deducted from the employee’s paycheck, making it easy to save consistently.

Contribution limits and withdrawals

The IRS sets annual contribution limits for 401(k) plans. For 2024, the contribution limit for employees is $19,500, with an additional catch-up contribution of $6,500 allowed for those aged 50 and older. Employers may also contribute, but the total combined contribution limit for both employee and employer contributions is $58,000 (or $64,500 for those aged 50 and older).

Withdrawals from a 401(k) can begin without penalty at age 59½. Withdrawals taken before this age are usually subject to a 10% early withdrawal penalty in addition to regular income tax, although there are certain exceptions, such as for significant medical expenses or permanent disability.

Considerations for a 401(k) plan

• Investment choices: 401(k) plans offer a range of investment options. It’s important to choose a diversified mix that aligns with your risk tolerance and retirement goals.
• Fees: Be aware of administrative and management fees associated with the plan, as these can impact your overall returns.
• Vesting schedule: Understand your employer’s vesting schedule, which determines when you gain full ownership of employer-contributed funds.

To further understand retirement planning and related concepts, you might want to learn about individual retirement accounts (IRAs), Roth IRAs, and the importance of diversification in investment portfolios.