How Does a 401(k) Work? 8 Frequently Asked 401(k) Questions

Have 401(k) questions? We’ve got answers to the most frequently asked 401(k) questions to demystify the most common type of retirement plan. Explore contributions, taxes, withdrawals, and penalties for your 401(k) plan.

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Key Takeaways

  • Employer matching can help you build your wealth, but you should understand vesting
  • Early withdrawal from a 401(k) typically comes with a penalty assessed on top of the taxes that must be paid
  • How much you can contribute depends on yearly IRS limits

If you’re like most Americans, when you think “retirement planning,” you first turn to the venerable 401(k) plan. After all, it’s the most common type of retirement plan. However, even though many workers use a 401(k) to save for the future, it’s not always easy to understand exactly how these plans work.

So, how does a 401(k) work? We’ve got answers to some of the most common 401(k) questions.

How Does a 401(k) Work?

Here’s the 401(k) explained: You put money into a retirement plan sponsored by your employer and the money hopefully grows with a tax advantage over time. In most cases, you choose how much money you want to contribute to your 401(k) based on a percentage of your income. Your employer automatically withholds a portion of each paycheck and puts it into the account.

With a traditional 401(k), this money is taken out of your paycheck before federal income taxes are figured, providing you with the chance to reduce your taxes today. You pay taxes on the money when you withdraw it from your account during retirement. In exchange for this increased tax efficiency, you agree to hold off on any withdrawals until you reach age 59 ½. Some employers offer a Roth 401(k) option. In a plan that allows Roth contributions, you don’t get an immediate tax deduction because Roth contributions are made with after-tax money. Instead, you expect that your money grows tax-free and you can withdraw it without paying taxes. 

How Much Can I Contribute to My 401(k)?

How much you can contribute to a 401(k) depends on the limits set by the IRS each year. The IRS takes a look at inflation and other market-related factors to determine limits on annual contributions. For example, for 2019, the limit is $19,000. For those 50 or older, the IRS allows “catch-up” contributions of up to $6,000 above the $19,000 limit.

However, it’s a good idea to review the annual limits because they might change. If you’re already contributing the limit, and it rises, you might want to adjust your contributions in the new year to boost your savings.

How Does 401(k) Matching Work?

When answering the question, “How does a 401(k) work?” one of the most important items to consider is the effect of matching. When an employer matches your contributions, you get free money to add to your account.

Typically, an employer match works by taking a portion of your contribution, up to a certain percentage of your income, and investing it in your 401(k). Most matches are expressed as a percentage of the contribution you make and are based on a percentage of the income you choose to contribute.

For example, let’s say your employer matches 50% of your contributions up to 6% of your income and you make $6,000 per month. If you wanted to get the full match, you’d set aside at least $360 per month (6% of your monthly income), and your employer would also kick in $180 to match the contribution you made. As a result, your retirement account would grow by $540 each month.

One of the common 401(k) questions about employer matching is whether the employer match counts toward your annual contribution limit. The good news is that it doesn’t. However, there’s a separate limit that affects overall contributions. For 2019, the combined contributions you make plus your employer contributions cannot exceed $56,000.

What Is 401(k) Vesting?

One of the most important things to understand is how 401(k) vesting works. Vesting is a term that describes how much of the money in your account is actually yours if you were to leave the company or take a distribution.

The contributions you make yourself are immediately vested and considered yours. However, in some companies, matching 401(k) contributions aren’t considered yours until you’ve remained with the company for a set period of time. So, if the company has a vesting schedule, you might not be able to keep all the money your employer invests on your behalf until after you’ve stayed at the company for one, three, or six years.

What Happens if I Make a 401(k) Early Withdrawal?

Generally, if you take money from your account before you reach age 59 ½, you’ll have to pay taxes on the amount at your marginal rate, plus pay a 10% penalty to the IRS.

Can I Make an Early 401(k) Withdrawal Without Penalty?

There are some exceptions to an early withdrawal penalty.

One exception is known as the Rule of 55—if you lose (or leave) your job at age 55 or older, and you take distributions from the 401(k) associated with your most recent job, you won’t have to pay the 10% penalty. Some of the other circumstances that might allow you to avoid the 10% penalty (but not the taxes) include:

  • Substantial medical bills
  • Military service
  • Permanent disability
  • A “Qualified Domestic Relations Order,” such as in a divorce settlement

You might have to provide documentation to avoid penalty in these cases, so make sure you’re prepared to do so.

Can I Contribute to an IRA and 401(k)?

Yes, it’s possible to contribute to both an IRA and a 401(k). However, if you are eligible to contribute to a 401(k), then your IRA deduction (not contribution) may be reduced depending upon your income.  Whether you actually contribute to the 401(k) is irrelevant, merely being eligible to do so means you will have to review your Modified Adjusted Gross Income to determine your IRA deduction.  But any IRA contributions you make do not affect your 401(k) contributions, nor the taxation of your 401(k) contributions.

How Much Should I Contribute My 401(k)?

Sometimes the issue of how a 401(k) works is less about the mechanics and more about how much you can contribute. How much you end up contributing to your 401(k) depends on your retirement goals and how much you hope to amass in your nest egg by the time you retire. While you don’t have to contribute the maximum allowed by the IRS, it’s worth noting that the more you invest now, the more of a head start you’ll likely have toward a comfortable retirement.

If you have more questions, be sure to ask a retirement specialist for more information about using a 401(k) to your advantage.

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Key Takeaways

  • Employer matching can help you build your wealth, but you should understand vesting
  • Early withdrawal from a 401(k) typically comes with a penalty assessed on top of the taxes that must be paid
  • How much you can contribute depends on yearly IRS limits
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