Investor's Manual: What Is a 401(k) Plan?

 A 401(k) plan is a defined-contribution plan where employees can make contributions from their paycheck before tax, but also after tax, if offered by the plan. The contributions go into a 401(k) account for each employee, with the employee often choosing investments based on the plan’s offering.

For the employer, these defined-contribution plans shift the responsibility of saving for retirement to the employee. As an extra benefit and incentive to save, employers often offer a matching contribution, usually as a percentage of the contribution the employee makes and is capped at percentage of the employee’s salary. For example, a common employer match is 50% of employee contributions up to 6% of an employee’s pay. In this case, the employer would give 50 cents to each employee for every dollar that the employee contributes. But the match would stop once employees contributed more than 6% of their pay to the plan.

With a traditional 401(k), an employee can make federal income tax-free contributions to an account (and usually exempt from state income tax, but not for all states). These elective deferral contributions are still subject to Social Security tax. The deferral contributions we hope will grow tax deferred, thus contributions and earnings are not taxable until withdrawn. Employer matching and profit sharing contributions, if made, we also hope and expect will grow tax deferred and are not taxable until withdrawn from the plan.

If the 401(k) allows Roth contributions, only employees may make this type of contribution, any employer matching will need to be pre-tax. Roth elective deferral contributions have been taxed, but then any gains are not taxed when the funds are withdrawn later (as long as the account has been opened for at least five years and the employee is age 59 ½).  Employees could still make pre-tax deferral contributions or make Roth deferral contributions or a combination of both types, but the maximum employee deferral contribution is still subject to the IRS annual limit ($19,000 for 2019 while employees age 50 or older can contribute an additional $6,000 as a catch-up).

All of these different contributions may be held in the same individual account but are then record-kept separately to track contributions and earnings. To do this record keeping, many employers hire a dedicated third-party administrator or benefits consulting firm. Some very small 401(k) plans may open two accounts for each individual participant: one account to hold the employee pre-tax deferral, employer matching, employer profit sharing contributions, and earnings. And, a second account for employee Roth elective deferral contributions and earnings on the Roth deferral contributions.

The workplace 401(k) isn’t your only choice. An Individual Retirement Account (IRA) is a tax-advantages retirement account for individuals. Learn more more about IRAs.

Finally, if you own your own business (even as a freelancer or side gig), you may be able to contribute to a small business retirement plan like a SEP IRA or Individual or Solo 401(k). These plans allow tax-deductible contributions and have higher maximum contributions than traditional IRAs and Roth IRAs.

Ready to Take Action?

You can roll over an old 401(k) to TD Ameritrade in three simple steps. We can help you take the next steps when you’re ready to roll over your old 401(k). Before rolling over a 401(k) to an IRA, be sure to consider your other choices, including keeping it the former employer’s plan, rolling it into a 401(k) at a new employer, or cashing out the account value keeping in mind that taking a lump-sum distribution can have adverse tax consequences. Whatever you decide to do be sure to consult with your tax advisor.  

Also, watch this video to learn more about retirement plans.