What is a 401K and How Does a 401(K) Work?

What Is a 401(k) Plan?

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How Does a 401(k) Work?

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When you enroll in a 401(k), you decide how much of your paycheque you want to contribute. That money is automatically deducted and deposited into your 401(k) account. You can typically choose how to invest it in mutual funds, ETFs, or other options provided in the plan.

Your money grows tax-deferred, meaning you don’t pay taxes on gains until you withdraw the funds (or, in the case of a Roth 401(k), you may pay no taxes at all when withdrawing in retirement).

What are the Types of 401(k) Plans?

There’s no one-size-fits-all approach when it comes to retirement planning. Here are the most common 401(k) plan types:

Here’s an elaborated explanation of each retirement plan in 4-5 lines:

1. Traditional 401(k)

   Traditional 401 (K) is a tax-deferred retirement plan where you contribute pre-tax income, reducing your taxable income in the present. Your investments grow tax-free until withdrawal. At retirement, you pay income tax on withdrawals. This plan works well if you expect to be in a lower tax bracket later.

2. Roth 401(k)

   You contribute after-tax dollars in Roth 401(K), meaning you pay taxes now. In retirement, withdrawals, including investment gains, are tax-free. This is ideal if you expect higher earnings or tax rates in the future. It offers tax-free income when you need it most.

3. SIMPLE 401(k)

   Designed for small businesses with fewer than 100 employees, SIMPLE 401(K) simplifies retirement savings for both employer and employee. Employers are required to make matching or nonelective contributions. It has lower administrative costs and offers immediate vesting, making it easier to manage.

4. Solo 401(k)

   Solo 401(K) is tailored for self-employed individuals or business owners with no full-time employees (except spouses). It allows higher contribution limits since you can contribute both as an employer and employee. You get significant tax benefits and flexibility in investment choices.

5. Safe Harbor 401(k)

   Safe harbor 401(K) plan helps employers avoid IRS testing by making mandatory contributions to employee accounts. All employees receive the same benefits and become immediately 100% vested. It ensures fairness and is great for attracting and retaining talent.

6. 403(b)

   403 (b) is offered to employees of public schools, churches, and nonprofit organizations. It functions similarly to a 401(k) but may offer different investment options and lower administrative costs. Contributions grow tax-deferred, and some versions allow Roth options.

7. Profit Sharing Plan

   Employers contribute directly to employee retirement accounts based on company profits, regardless of employee input. Contributions are discretionary and flexible, allowing businesses to reward employees when the company does well. Profit sharing plan complements other retirement plans and boosts employee morale.

What is the Maximum 401(k) Contribution for 2025?

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Whether traditional or Roth, an employee can defer a maximum of $23,500 for 2025 ($23,000 for 2024, $22,500 for 2023, $20,500 for 2022) from his/her salary to a 401(k) plan.

For employees aged 50 years or older, an additional catch-up contribution of $7,500 ($7,500 for 2024, 23, and $6,500 for 2022) is allowed, and those who turn 60, 61, 62, or 63 in 2025 can contribute an enhanced catch-up amount of $11,250.

An employer and employee can make a maximum joint contribution of $70,000 for 2025 ($69,000 for 2024, $66,000 for 2023, $61,000 for 2022), or $77,500 for those 50 years and above ($76,500 for 2024, $73,500 for 2023, $67,500 for 2022).

Penalty-Free 401(k)/Non-Financial Hardship 401(k) Withdrawal

A penalty-free withdrawal allows you to withdraw money before age 59 ½ without paying a 10% penalty, but your withdrawal is taxable. To qualify for penalty-free withdrawal, you need to meet any of these situations:

• You need to have a disability that qualifies you for this type of withdrawal

• Your medical expenses are up to the amount that is allowed as a medical expense deduction

• You are ordered by the court to give money to your divorced spouse, your child, or a dependent

• You’ve experienced a disaster for which the IRS has granted relief

• You’ve left the company and have set up a schedule to make equal periodic payments for at least 5 years or until you turn 59 ½ years, whichever is longer

Contact your HR department to check whether your employer allows such kind of withdrawals and, if yes, how you should proceed.

401(k) Required Minimum Distributions (Post-Retirement Rules)

In April, the year after you turn age 72, you have to start taking 401(k) withdrawals, regardless of whether you want it or not. If you miss taking these required minimum distributions, or if you withdraw the wrong amount, the IRS will penalize you.

These RMDs are calculated based on your life expectancy. Your plan administrator must determine your RMD. So, check the IRS’s RMD rules to determine your required minimum distribution.

401(k) Distributions in Retirement

Once you turn 59 ½, you can start making withdrawals. You can typically take a periodic distribution or a lump sum distribution. The key here is to manage your distributions so that you don’t outlive your money.

Although a lump sum gives you access to a larger amount of money, it is taxable, and you have to pay the tax right away. Moreover, it takes away a major chunk from your nest egg, all at once.

If you do not wish to withdraw a lump sum, and if your company allows, you can choose to receive a certain amount of money every month or every quarter. If you want to change the amount, you can do so once a year. However, there are some plans that allow you to make changes more frequently.

What are the Pros and Cons of a 401(k)?

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Let’s weigh the benefits and drawbacks of using a 401(k) to plan for retirement.

Pros:

• Employers may offer to match a portion of what you contribute to a 401(K)
• Higher contribution amounts than allowed in SIMPLE IRA or SEP plans
• Disciplined savings through automatic payroll deductions
• Tax-deferred growth on investments while in the 401(k) plan
• Access to a wide range of investment options
• Control over when taxes are paid on retirement assets (pre-tax versus post-tax Roth contributions)
• Reduced taxable income through pre-tax salary contributions
• Option to take a loan from retirement savings
• Tax credits for some employees
• Ability to transfer assets to other retirement accounts when retiring or changing jobs

Cons:

• Limited investment choices within plan menus
• Hidden fees can eat into your returns
• Lack of liquidity, particularly early withdrawals, comes with penalties
• You must take RMDs, which can complicate tax planning later in life

What is the Difference Between a 401(k) and an IRA?

Many people ask, What is the difference between a 401(k) and an IRA? A 401(k) is a retirement plan provided by an employer, often with higher contribution limits and the benefit of employer-matching contributions.

On the other hand, an IRA (Individual Retirement Account) is something you open on your own and typically offers a wider range of investment options. While both are designed to help you save for retirement, the 401(k) is workplace-based, whereas the IRA gives you more personal control over your investments.

Both accounts offer valuable tax advantages. The right one for you may depend on how much control you want and your employment status.

Here’s a simple breakdown:

Feature	401(k)	IRA
Who sets it up	Employer	Individual
Contribution limit (2025)	$23,000	$7,000
Catch-up (50+)	$7,500	$1,000
Investment control	Limited to plan offerings	Wide range of options
Employer match	Yes (often)	No

FAQs About 401(k)s

• What is 401(k) vesting?

  Vesting refers to how much of your employer’s contributions you own. Your contributions are always 100% yours, but employer matches may vest over time, often based on how long you stay with the company.

• What do I do with my 401(k) if I change jobs?

  You have a few options:

  • Leave it in your former employer’s plan
  • Roll it over into a new employer’s plan
  • Move it into an IRA
  • Cash out (but penalties and taxes may apply)

• What happens if I make a 401(k) early withdrawal?

  Unless an exception applies, early withdrawals (before 59½) come with a 10% penalty and are taxed as income.

• Can I contribute to both an IRA and a 401(k)?

  Yes! You can contribute to both, but income limits may affect whether your IRA contributions are tax-deductible.

• How to build a 401(k) portfolio?

  Diversify based on your age, risk tolerance, and retirement timeline. A mix of index funds, bonds, and stocks often works well. Consider target-date funds if you prefer a hands-off approach.