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What is a 401(k) Plan and How Does It Work

What is a 401(k) Plan and How Does It Work

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The easiest way to get started saving for retirement is to use your employer’s 401(k) plan. A 401(k) is a retirement savings plan sponsored by your employer. It lets you save and invest a portion of your paycheck before income taxes are taken out. The specific rules and investment options vary from plan to plan, so it is a good idea to consult your employer and/or plan manager for the specifics. Many large and medium-sized companies provide a 401(k) plan as a retirement saving option for their employees, so it is reasonably accessible.

What is a 401(k) Plan and How Does It Work 1

Table of Content

What are the Benefits of 401(k)

401(k) Advantages

Here are a few reasons why participating in your employer’s 401(k) plan is a great idea.

1. Automatic Retirement Saving

Once you set up your 401(k) election with your employer, it is automatic going forward. At most, you have to review the plan once a year to make sure you are contributing the right amount and that you still have the proper asset allocation. See below for more information about how much to contribute and how to set that up.

2. You Never Handle the Money

Your 401(k) contributions come out from your paycheck before you get to touch it. This is a great way to “pay yourself first” and not allowing yourself to do something else with the money.

3. Tax Deduction and Deferral

Your 401(k) contributions are tax-deductible. You still have to pay Social Security and Medicare taxes, but you do not have to pay income taxes on your 401(k) deposits, thus lowering your taxes for the year. Your money grows tax-deferred, and you pay income taxes at your marginal tax rate when you withdraw the money.

4. 401(k) Matching is Free Money

One of the best reasons to use your employer’s 401(k) plan is many companies will match your contributions up to a certain limit. Every employer is different, so be sure to learn how your match works. One company might match your contributions dollar for dollar up to 6% of your pay (very common), while others might match 50 cents to the dollar of every dollar contributed up to 5% of your pay. This is something you will have to discuss with your plan administrator.

5. Easy Investment Choices

Starting your retirement investing with a 401(k) is a good idea because they only give you a limited number of investments (usually mutual funds) to choose from. Some will make it even easier by offering you Target Date Fund, where you just have to pick and invest in one fund.

6. Financial Safety

All 401(k) plans must comply with the Employee Retirement Income Security Act (ERISA), so there are safeguards put in place to protect your interest. Secondly, since your investment options are limited to a fairly decent selection of funds, it is hard to do something stupid with the money inside your 401(k) plan.

7. Free Financial Advice

Most employers and plan administrators will provide you with free financial advice to help you maximize your company benefits, including making the most out of your 401(k) plan. Granted the free advice is limited, but this advice comes at the right price if you’re just getting started.

8. Dollar Cost Averaging

Since you’re automatically adding money every paycheck, you are taking advantage of the Dollar Cost Averaging strategy. DCA allows you to buy more shares when the prices go down and fewer shares when the prices go up.

401(k) Disadvantages

There are some disadvantages, but I would not let these discourage you from investing in a 401(k) plan, especially if your employer offers a match.

1. Limited Investment Choices

Yes, I said it was an advantage, but it is also a disadvantage. Unlike IRA where you have access to every investment imaginable, you’re most likely looking at 5-10 investment choices in your 401(k) plan. These funds may not meet all your requirements as far as expenses ratio, turnover ratio, asset allocation, diversification, etc.

2. Expensive Funds

I find that many of these funds tend to have a higher expense ratio compared to what I would typically invest in outside my 401(k). However, you can only choose from what the plan offers. If that S&P500 fund has an expense ratio of 0.6%, you don’t have a choice.

3. Plan Expenses

In addition to expense ratio, your plan might come with a cost. There are other fees such as an administrative fee and service fee that the employer may not pay and pass along to you. This fee, if large enough, could cause a significant drag on your portfolio performance. See: How 1% Expense Ratio Kills Your Investment Returns.

4. Subpar Investments

Another disadvantage of 401(k) is that you don’t have that many choices to choose from. If your plan offers you below-average investments, that is what you have to work with.

Despite these disadvantages, 401(k) is still a good investment for the most part. And in almost all cases, you should contribute to your 401(k) because the cost of not participating or delaying so you can make “perfect” investment choices is much higher than just getting started.

What is 401(k) Matching and How It Works

401(k) matching is the extra contribution that your employer pays into your 401(k) account. This matching contribution does not count against your yearly contribution limit, and the matching amount varies from employer to employer.

  • It could be as little as no matching at all
  • It could be a $1 for $1 matching, or a 50 cents for $1 matching, up to a certain percentage of your annual income, e.g., 3% and 6% is quite common
  • It could be done per paycheck, or it could be done once a year (or each quarter)

You have to ask your employer for the specifics of your matching program.

How Matching is Calculated with an Example

Assuming you earn $50,000 a year and your company contributes $1 for $1 matching up to 6% with each paycheck. Assuming you get paid twice a month and you decided to contribute $500 from each paycheck — your total contribution for the year will be $12,000 ($500 x 24)

For the first three months, your company will contribute $500 each time you put in $500 (in a $1 for $1 matching), and they will stop their contributions once they contributed the full $3,000 for the year (6% of $50,000 is $3,000).

After you reached the maximum matching limit, your company stops, but you can still contribute up to the annual limit allowed by the IRS.

Take 401(k) Match or Pay Down Debt

If you have to decide between paying down a 20% credit card debt vs. contributing to get your company’s match, which one should you choose? Quick answer…take the match.

Let’s assume you have $250 extra a month to put toward debt or 401(k); this is how the math works out.

  • Paying Credit Card: $250 x 20% saves you $50. On average, you have to earn $1.55 to get a dollar after taxes; this means the $50 saved is equivalent to about $78 earned.
  • 401(k) Match: $250 invested results in a $250 match (assuming a $1 for $1 matching). At 23% federal and 5% state, you’re saving $70 in the form of tax deduction, which is equivalent to $109 earned. The two add up to $359 value!

You can adjust the match to fit your exact situation, and you’ll find in most cases, taking the company match wins!

Is 401(k) Worth It If Employer Doesn’t Match?

The answer is ABSOLUTELY YES…BUT

If your company doesn’t match your 401(k) contribution, you should first contribute to a Roth or a Traditional IRA until you max out the $6,000 limit.

Why?

Because IRA offers a much more extensive selection of investments, and you can manage the fees so that it is much lower than what you’d pay inside your 401(k) plan.

What is the 401(k) Matching Average?

According to Fidelity Q1 2019 Retirement Savings Update based on 30 million retirement accounts they manage:

The average 401(k) employer contribution rate, in terms of percentage of salary, reached 4.7% in Q1, which was also a record high and boosted the average total savings rate (employee contributions + company match) to an all-time high of 13.5% in the first quarter.

How to Set Up Your 401(k)

The process of setting up your 401(k) is straightforward.

1. Sign Up to Participate in Your 401(k) Plan

When you join the company, you should have the option of signing up to participate in your 401(k) Plan. If you are not yet participating, ask your manager about who to contact to set this up. You might have to fill out some paperwork that includes your application to participate, beneficiaries form, investment election form, etc.

2. Decide How Much to Contribute

According to the IRS, 401(k) contribution limit increases to $19,000 in 2019, and the catch-up contribution limit for employees aged 50 and over remains unchanged at $6,000. The important decision to consider is as follow:

  • If your company doesn’t match, you should plan to contribute the maximum to your IRA first before you contribute to your 401(k).
  • If your company matches, you should plan to contribute to your 401(k) first until you use up all of the matching amounts (e.g., “contribute up to matching”), switch over to your IRA contribution, and come back to contribute more to your 401(k)

Some employers allow you to change your contribution by merely logging into your 401(k) web site; for others, it takes a little bit more planning. If you plan to max out both accounts, the math for maximum contribution is quite simple.

  • For 401(k), divide $19,000 by the number of pay periods, e.g., $19,000 ÷ 24 = $791.66. That is how much you’ll be deducting from your paycheck each time.
  • For IRA, you can most likely set up an Automatic Investment Plan that invests $500 a month so that you max out the account at $6,000 by the end of the year.

If you contribute less than the maximum, you will have to plan out your contributions accordingly.

3. Invest Your 401(k) Money

Remember that when you deposit money into your 401(k) plan, it sits in the default account. For some, this is a basic money market account that pays next to nothing, or others; the money could default to investing in a Target Date Fund based on your age.

If you want to manage your Asset Allocation, you will have to choose how the money will be distributed among various funds. Typically, every 401(k) plan comes with some basic variations of US Large Cap Stocks Fund(s), US Small Cap Stocks Fund(s), International Stocks Fund(s), and Bonds Fund(s).

For further discussion of asset allocation, see Asset Allocation, Diversification, and Rebalancing.

4. Rebalancing

You are pretty much done at Step 3, but you should set up a schedule to review your 401(k) at least once a year to make sure you’re still correctly allocated according to your Asset Allocation Plan. It is important to note that you should do a combined asset allocation of all your portfolios and not just each account separately.

Some 401(k) offers automatic periodic rebalancing which will bring your investments in line with how you choose to invest your money….fancy!

Maximum Contribution Limits

As mentioned above, according to the IRS, 401(k) contribution limit increases to $19,000 in 2019, and the catch-up contribution limit for employees aged 50 and over remains unchanged at $6,000.

Unless…

401(k) Limit for Highly Compensated Employees

According to the IRS, a Highly Compensated Employee (HCE) is an individual who:

  • Owned more than 5% interest in the business at any time during the year or the preceding year, or
  • Received compensation from the business of more than $120,000 (for 2018) or $125,000 (for 2019) in the previous year, or
  • The employer designates you as an HCE because you are in the top 20% of employees when ranked by compensation.

If you meet any of these conditions, your contribution cannot be more than 2% higher than the average contributions made by non-HCE employees. For example, if the average contributions made by non-HCE is 5% of their salary, then you can only contribute a maximum of 7% of your salary.

Can You Contribute to an IRA and a 401(k) in the Same Year?

The short answer is YES you can contribute the maximum of $19,000 to your 401(k), or $25,000 if you’re 50 or older, get the company matching on top of that, and still max out your IRA….the long answer is a little more complicated.

If your income (for single taxpayers) or combined income (for married couples) exceed a certain amount, your IRA is subject to a phase-out

…more about that in the IRA Guide.

Many employers have now automatically enrolled their employees into the 401k plan when they are first hired. As you go through your paperwork, there is an option not to automatically enroll, but a majority of people go ahead and sign up. Automatic enrollment usually starts you at about 3% of your pay, and most people don’t miss the amount from their check. However, 3% is probably not enough savings for you to retire on, so be sure to go back and increase the percentage if you can afford it. (You can also change the contribution amount when you first sign up for the plan.)

For more information, see Maximum 401(k) Contribution and Catch-Up Limits for 2018-2019.

401(k) Withdrawal

At the beginning of this guide, you learned that 401(k) contributions are tax-deductible, your money grows tax-deferred, and you’re taxed when you withdraw the money. When you plan your withdrawal, consider the safe withdrawal rate to ensure that you have enough money left to last your lifetime. There are three phases of 401(k) withdrawal based on your age.

1. Early Withdrawal

If you take money out from your 401(k) before you turn 59 1/2, you will be subject to a 10% early-withdrawal penalty in addition to the income taxes you pay. However, there are some exceptions according to the IRS.

Since this is a fairly complex issue that could cost you a lot of money, my advice is to consult a tax professional if you plan to go this route.

2. Retirement-Age Withdrawal

Once you reached 59 1/2, you can start withdrawing from your 401(k) without penalty. However, you need to decide which retirement account you want to begin withdrawing from first. This is a fairly complex issue that involves a full understanding of your available retirement accounts, your income sources, your tax bracket, and your income needs to determine the most optimal withdrawal amount and from which accounts.

Again, I’d advise you to consult a tax professional or a financial planner for this step.

3. Required Minimum Distribution

Before April 1st of the following year in which you reached 70 1/2 or retire (whichever is later), you must begin to take the required minimum distribution (RMD). To calculate your RMD, it is probably much easier to use an RMD Calculator like this one provided by Schwab, or FINRA, as opposed to using the IRS RMD Worksheets.

Other Important Things to Know About 401(k)

401(k) Rollover

When you leave your job, voluntarily or involuntarily, you have choices with regard to your 401(k)

  1. Cash Out Your 401(k): A BAD idea
  2. Keep Money in Your Current Plan
  3. Rollover to Your New 401(k) Plan
  4. Rollover to an IRA: the BEST option

See: How to Rollover 401(k) to IRA

401(k) Loan

If you are in need of money, your 401(k) is an option where you can borrow money from. In general, the IRS allows you to borrow the lesser of 50% of your vested account balance, or $50,000 minus your highest outstanding loan balance in the last 12 months. Here is more information about 401(k) Loan.

401(k) Plan for Self-Employed Individuals and Small Businesses

If you are a self-employed individual or a small business owner, you could set up an Individual Solo 401(k) Plan. A solo plan is similar to a traditional plan with contribution limits of $19,000, or $25,000 if you’re 50 or over. In addition, the employer could contribute up to 25% of your pay as long as the total contribution doesn’t exceed $56,000.

For more information, visit IRS.gov One-Participant 401(k) Plans.

For my business which is structured as an S Corporation with my wife and me as the only employees, we set up our Solo 401(k) with Vanguard.  We have access to more than 100 Vanguard funds, but only have one Target Date Fund in the plan since it costs $20 per fund. There is no setup fee and it was fairly easy to get one established. There is no annual filing requirement unless your plan’s asset exceeds $250,000, in which case you will have to file Form 5500 annually.

Roth 401(k)

Roth 401(k) is newer to the retirement saving scene, but it is becoming more common every day. Similar to a Roth IRA, a Roth 401(k) allows you to make contributions after taxes have been taken out, then your investment grows tax-free!

With a Roth 401(k),

You can also take advantage of your employer’s matching contribution.

It has the same contribution limits as a Traditional 401(k), i.e., $19,000, or $25,000 if you’re 50 or over in 2019

Traditional Roth
Contributions Before Income Taxes After Taxes
Withdrawal Pay Income Taxes at Marginal Rate Not Taxed

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What is a 401(k) Plan and How Does It Work

by Pinyo Bhulipongsanon time to read: 12 min
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