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401k plan and how it works: The full breakdown

At a glance:

  • 401k plans versus traditional pensions

  • Understanding the details of your 401k plan

  • Making contributions to a 401k plan

  • 401k plan distribution requirements

  • Finding the right mix for your 401k

  • What is a SIMPLE 401k plan?

  • What is a Roth 401k?

  • 401k rollovers

  • Summary of 401k plans

The Revenue Act of 1978 created new retirement options for employee benefit plans.

Under section 401k of the Internal Revenue Code, employers may offer their employees the option of taking cash payments currently or deferring the cash until retirement. Employees may also elect to defer current income to the plans on a pre-tax basis.

This simply means that the employees can invest money into the plans before the money is taxed, thereby making it tax-free for the present.

Employees can save thousands of dollars each year by choosing this option. Some plans also allow employees to make after-tax contributions to a savings plan. Profit sharing plans, savings plans, and stock bonus plans may include provisions for a 401k.

UNITED STATES - OCTOBER 31: Senate Minority Leader Chuck Schumer, D-N.Y., holds a news conference with Sen. Maria Cantwell , D-Wash., and Sen. Ron Wyden, D-Ore., to unveil a plan to protect and expand retirement savings on Tuesday, Oct. 31, 2017. (Photo By Bill Clark/CQ Roll Call)
Senate Minority Leader Chuck Schumer, D-N.Y., holds a news conference to unveil a plan to protect and expand retirement savings in 2017. (Photo: Bill Clark/CQ Roll Call)

401k plans versus traditional pensions

The pension is fast becoming a thing of the past. These days, more and more companies are adopting cryptically titled retirement packages called 401k plans.

A 401k plan (as well as its cousin, the 403b plan) is a defined contribution plan. This means that the amount you receive in retirement is based on the amount that you (and your employer, if there's a match available) contribute to the plan, in addition to the investment returns you earn on those contributions.

In contrast, "defined benefit plans," such as pensions, generally pay a guaranteed sum based on your wages and years of service.

As investment programs, 401k plans have several great features:

They're automatic

You can't forget to invest — your employer deducts your contribution from each paycheck. This forces you to invest regularly, even when the markets are down.

They invest pretax dollars

Your investment doesn't take as big a bite from your paycheck as you might imagine, because you're investing pretax dollars in your 401k plan.

As a result, a $100 contribution doesn't result in a $100 reduction in your take-home pay. In fact, you can save money on your income taxes now by investing in your 401k: The income figure that the IRS uses is income after 401k contributions.

You don't pay taxes on investment gains until later

Mutual funds make distributions, bond funds pay income, and equity funds often distribute capital gains. Unless you hold your mutual funds in a tax-deferred account (such as a 401k plan), you're responsible for paying taxes on these distributions, as well as on any gains you realize by selling an investment.

By investing in a 401k plan, however, you don't have to come up with more money for the tax man right now. You won't pay taxes until you begin withdrawing money from the plan.

Many employers match all or part of your contribution

For every dollar you contribute to your plan, your employer might invest an additional 50 cents. Some plans are more generous and match "dollar for dollar" on at least a portion of the employee contribution. That's like getting an instant 100% return on your investment.

Say you earn $35,000 a year and contribute 10% of your income to your 401k plan. If your employer matches 100% on the first 4% of your contribution, your total contribution to the plan is $4,900. That's $3,500 from you and $1,400 from your employer. Over 10 years time, that $1,400 per year really adds up.

Given that this is really free money, try to contribute at least enough to your 401k plan to get the full employer match.

You control your own investments

401k plans have shifted the risk of getting good investment results from employers to employees. You choose your own investments from a menu of options. 401k plan participants have greater freedom to control their financial futures than pension recipients do.

If you're an aggressive investor with a long time horizon, you can opt for the plan's racier options. Or, if you're near retirement age, you can be as conservative as the plan allows. It's up to you.

Understanding the details of your 401k plan

Every 401k plan has an excruciating legal description, called the plan document. No need to pore over that. Focus instead on the summary plan description (SPD). That document explains how your plan operates.

Look for the answers to these questions:

  1. How long do you have to work for your employer before you're eligible to participate in the 401k plan? Some companies let you start immediately, while others make you wait.

  2. How much of your salary can you contribute? The limit is set by law, but some plans have a lower ceiling based on a percentage of employees' salaries.

  3. How much of your contribution will the company match? Most employers complement what their employees stash away.

  4. What are your investment options? Most plans include mutual funds, and some have individual stocks — usually the employer's.

Making contributions to a 401k plan

Both employers and employees may contribute to a 401k plan. Contributions to a 401k plan can take several forms:

Matching contributions

These are contributions that an employer makes to an employee's plan after the employee has contributed.

For example, assume the employer agrees to deposit (or match) 50 percent of the employee's first 10% deferral. In such an instance, if the employee deposited 10%, the employer would add an additional 5%. The total percentage deposited for the employee therefore would equal 15%.

Elective contributions

These are before-tax contributions made by an employee. They are funds that the employee could have taken as a cash amount but instead deferred to the plan. They are also called elective deferrals.

401k plan contribution requirements

A 401k plan has certain requirements. The plan must be part of a qualified stock bonus plan or profit-sharing plan. (A grandfather clause allows a pre-1974 money purchase pension plan to include 401k provisions.) The Employee Retirement Income Security Act was passed in 1974 and altered many rules on pension plans.

Eligibility requirements can be set for minimum age and service (for example, employees 21 and older with 1,000 hours of service).

Contribution limits

Total contributions (employee and employer) are limited to the lesser of 100 percent of the employee's compensation or $57,000 for 2020. Employer contributions are not required, however, so employers have flexibility in matching their employees' contributions.

  • The maximum employee contribution is $19,500 for 2020. A "catch-up" provision of the law allows taxpayers over age 50 to contribute an additional $6,500.

  • As long as all employees are covered by the plan, there is no minimum number of employees needed for a plan to exist. (Employees covered by a collective bargaining agreement may be excluded.)

  • Employees are always 100 percent vested (meaning they have the right to take their accumulated pension money out of the fund) in their elective deferrals. Vesting of non-elective (employer) contributions is subject to a schedule depending on the terms of the plan.

  • All 401k contributions (employer and employee) are deductible by the employer.

Millennials aren't contributing as much to their retirement. (Graphic: David Foster/Cashay)
Millennials aren't contributing as much to their retirement. (Graphic: David Foster/Cashay)

IRS approval required

401k plans are very flexible, but they must meet IRS requirements to qualify for special tax treatment. These requirements include contribution limits as well as requirements as to how the plan is established and who may participate.

401k plan distribution requirements

Penalty-free distributions from a 401k plan are allowed only for the following events:

  • Termination of employment — with rollover into another plan

  • Retirement (age 59½ for most plans)

  • Certain hardships (such as medical expenses or college tuition). Significant restrictions and/or penalties may be imposed on hardship withdrawals prior to age 59½.

  • Distributions or withdrawals made to an alternate payee as part of a qualified domestic relations order, such as under a divorce settlement.

  • Death or disability

  • Distributions made as part of a series of substantially equal annual payments made over your life expectancy.

First-time home purchase is not one of these cases.

Know your plan in and out

As with any account into which you put your money, your company's plan rules may have additional restrictions. Be sure to study your plan carefully and ask questions.

Finding the right mix for your 401k

What do people do when they don't know which investment options to pick? They choose them all.

That's a bad idea. Your 401k plan isn't like a smorgasbord where you can try a little of everything. It's important that you understand your investment choices and that you choose the ones that will allow you to reach your investment goal.

How your sponsor can help

Many 401k plan sponsors offer retirement planning tools. This can make finding the right mix of funds for your retirement plan easy.

All you typically have to do is answer some questions about your age, how much you're currently contributing to your retirement plan, your income goals in retirement, whether you'd be willing to work part-time when retired, and a few questions that will help the program gauge how much risk you're comfortable with.

Retirement-planning tools can analyze that information and the funds your retirement plan offers, weighing their strategies, risks and returns, and expenses. They often give you the odds that you will meet your goal and recommend a mix of funds to get you there (put 45% in Fund Z, 23% in Fund Y, and so on).

If the chances of you achieving your goal are poor, you will have the option of revising some of your parameters

What is a SIMPLE 401k plan?

Employers may set up SIMPLE 401k plans for their employees.

The SIMPLE (which stands for "savings incentive match plan for employees") is an alternative to regular 401k plans. The SIMPLE plan is much easier to administer, but it has greater limitations.

How much you can defer into your plan per year

For 2020, the employee may defer up to $13,500 under a SIMPLE 401k, compared to $19,500 under a regular 401k. Employees over 50 may make an additional "catch-up" contribution of $3,000.

Under a SIMPLE 401k, the employer must match up to 3 percent of the employee elective deferrals. Alternatively, the employer may elect to make a 2 percent (non-matching) contribution (limited to $285,000 in 2020) of compensation to all eligible employees, whether they defer salary or not.

The 401k is a very popular retirement plan because both employers and employees can contribute on a tax-deductible basis.

What is a Roth 401k?

The Economic Growth and Tax Relief Reconciliation Act that became effective in 2006 did for 401k plans what the US government did for individual retirement accounts a few years earlier: it established a Roth version.

Employers who provide 401k plans to their employees now have the option to offer this new version as well. Essentially, the Roth 401k works the way a Roth IRA works.

Any contributions made to the plan are not eligible for tax deduction.

However, when the funds are withdrawn (provided that you are at least age 59½ and your account is at least five years old), they are not taxed. An extra bonus is that any growth in the account, whether by appreciation or earnings that you reinvested, is also not taxed.

Here are some more things to remember about the Roth 401k

  • There are no yearly income limits that you must fall under in order to contribute to a Roth 401k, as there are for a Roth IRA. Also, you may contribute to both a standard 401k and a Roth 401k, provided that you do not exceed the yearly maximum. For 2020, the limit is $19,500.

  • Employers may contribute matching funds to their employees' Roth 401ks. However, these matching funds are not after-tax, like the contributions made by employees. They are before-tax, meaning that they must be kept separate from Roth account funds. Upon withdrawal, then, the matched portion of the account will be subject to federal income tax.

  • As with standard 401ks, you will be penalized for taking withdrawals before age 59½. You will also be required to take distributions beginning at the age of 70½. On your income tax forms, your Roth distributions will not be counted as income. Those matched by your employer will be.

Is the Roth 401k for you? It can certainly be advantageous if you expect to be in a higher tax bracket after age 59½ than you are today.

Thus, it may help for you to determine whether tax breaks now or tax breaks later in life will be more important.

It's worth checking into

Even if you are unsure about your future tax rates, a Roth 401k might still be to your benefit. It may be worthwhile to consult a financial planning professional who will work through a variety of hypothetical scenarios with a computer to help you make an informed decision.

401k rollovers

A 401k rollover is the moving of a 401k plan from its current custodian (the company holding it) to another. The following requirements must be met so that the 401k may keep its tax-deferral:


  • The new 401k plan must accept rollovers.

  • If you prefer (or if the new 401k does not accept rollovers), your original 401k funds can be rolled over into a traditional IRA. (Rollovers into Roth IRAs are also allowed in some circumstances.)

  • The full amount from the original account must be placed into the new 401k (or IRA) within 60 days. If a lesser amount is rolled over, penalty taxes will be applied.

Types of 401k rollovers

Direct rollovers

You can move the funds via a direct rollover (trustee-to-trustee transfer), in which the funds are transferred from the old custodian to a new one without you touching them.

This is usually the smoothest method because it doesn't incur tax penalties or withholding by the IRS.

Self-directed rollovers

You can also remove the money from the old account and put it into the new account yourself.

However, with this method, the IRS requires that 20% of the funds be withheld for tax purposes, even if you intend to roll the money over to a new 401k or IRA. You will then have to deposit the full rollover amount in order to avoid an early withdrawal penalty.

This means you will need to come up with an amount equal to the 20% that was withheld. Once you have done so, however, the withheld 20% will be returned to you.

Recent benefits

Non-spouse beneficiaries now enjoy a benefit they did not have prior to 2006: the ability to transfer inherited 401k and other qualified plan and IRA accounts into a new IRA.

The transfer (though similar, this is technically not a "rollover") must be by a direct trustee-to-trustee transfer. In the case of funds from a qualified plan, that plan must allow such transfers. The new IRA must be titled as an inherited IRA — something like "John Doe IRA, deceased, for the benefit of Junior Doe."

The non-spouse beneficiary's (Junior's) Social Security number will be used, however. This arrangement allows the non-spouse beneficiary to stretch payments over his or her life expectancy to increase the deferral of taxes. The non-spouse beneficiary (say, Junior) may name his own beneficiary, but this new beneficiary must continue to take distributions over Junior's life expectancy.

Roth 401k-to-Roth 401k rollovers

It should be noted that a Roth 401k can be rolled over tax-free into another Roth 401k. A traditional 401k cannot be rolled tax-free into a Roth, however. (Otherwise, those rolled-over dollars would totally escape taxation.)

Instead, a tax-free rollover from a 401k or other qualified plan can be made into a traditional IRA, followed by a taxable conversion to a Roth IRA. In the past, one's income needed to be under $100,000 to be able to convert from a traditional to a Roth IRA.

The IRS conversion rules have changed and there is no longer an income cap in place. (There are still income limits for contributions to Roth IRAs, however.)

401k-to-Roth IRA rollovers

Beginning in 2008, however, subject to those same conversion rules, direct rollovers will be allowed from 401k and other qualified plans directly into a Roth IRA. (In other words, there will be no need to create a traditional IRA as a conduit in this process.)

Summary of 401k plans

The 401k is a very popular retirement plan because both employers and employees can contribute without taxation to the employee until funds are withdrawn.

It is becoming more popular with employers who want to offer retirement benefits but who cannot afford a traditional defined benefits plan.There are many variations on the 401k plan formula that make the plan flexible enough for almost any employer.

The plan distribution options also make it very attractive to employees who may or may not remain with the same employer until retirement age.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

Read more information and tips in our 401k section

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