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What Is a 401(k)?

Managed properly, a 401(k) plan can be a path to a comfortable retirement.

Americans held $7.7 trillion in 401(k) plans at the end of 2021, making the 401(k) retirement plan one of the most commonly used retirement investment vehicles in the U.S.

What are 401k plans and why are they so widely used? Here’s a closer look.

Tax-Advantaged Retirement Plan

A 401k plan is a tax-advantaged retirement vehicle that many U.S. companies offer to their employees. The term 401(k) refers to a section of the U.S. tax code covering retirement plans.

A company sets up a 401(k) plan for their staffers, who sign up for the plan and agree to have a portion of their regular paycheck withheld and deposited into into their 401(k) plan account.

With 401(k) plans, employees can choose among several investment vehicles to fund their retirement, including:

  • Index funds 
  • Target-date funds
  • Mutual funds
  • along with individual stocks, bonds, and money market funds.

Plan holders are limited to a maximum 401(k) plan contribution limit each year, up to $20,500 for 2022, according to the IRS. Employees can invest up to the maximum amount, and also get matching contribution help from their employers.

For example, an employee earning $50,000 annually might contribute 10% of that pay into a 401(k) plan on an annual basis, or $5,000. 

Additionally, that employee could receive 100% matching contribution from their employer up to 5% of the worker’s annual earnings, or $2,500. In total, the employee is contributing $7,500 to a 401(k) plan for the year, which can be invested for retirement on a tax-deferred basis.

The IRS also allows an additional 401(k) “catch-up” contribution of $6,500 annually for Americans ages 50 and older.

Read: How to Retire Rich? Start Saving and Investing Now

Traditional 401(k) and Roth 401(k)

 An employee may be able to choose between a traditional 401k or a Roth 401k plan. 

Traditional 401k plan: The more widely used 401(k), a traditional 401(k) plan allows workers to contribute the plan before any taxes are withheld, reducing the employee's taxable income.

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A Roth 401(k) plan: On a tax basis, Roth 401(k) plans are treated differently than traditional 401(k) plans. Instead of having taxes deducted from an employee’s gross income, Roth fund contributions are made after income taxes have been taken out of the employee’s paycheck.

Read: Can I Contribute to My Roth 401(k) Regardless of My Income?

The two plans differ on the back end, too. Unlike a traditional 401(k) plan, where the employee pays taxes on plan withdrawals in retirement, a Roth 401(k) allows plan holders to avoid paying taxes on plan withdrawals in retirement.

While employees typically choose between a traditional 401(k) and a Roth 401(k), the IRS allows 401(k) investors to opt for a mix of both plans in their company-sponsored retirement portfolio -- but only up to specific annual limits on tax-deferred 401(k) plan contributions.

Read: Comparing Roth IRAs and Roth 401(k)s

401(k) Withdrawals

In general, 401(k) plan holders can start making withdrawals from their 401(k) account upon reaching the age of 59-and-a-half, or can start taking out money earlier if they are disabled and meet specific IRS 401(k) plan early withdrawal criteria.

If a 401(k) plan holder takes money out early in the form of a loan and doesn’t pay the loan back in full and under a specific timeline, that plan holder usually must pay a 10% early withdrawal penalty on top of other taxes they owe the IRS. 

Required Minimum Distributions

While a retirement saver can defer taxes on retirement savings, they can't be put off forever. Folks with tax-deferred accounts, such as a traditional 401(k)s or IRAs, are required to take distributions from those accounts every year after reaching a certain age. 

Retirement savers born after June 30, 1949 must begin taking these required minimum distributions by April 1 of the year they turn 72. 

Those born before July 1 1949 were required to start taking their RMDs by April 1 of this year, will have to take another distribution by Dec. 31, 2022 and by Dec. 31 of each year after that.

The penalties for failing to take required minimum distributions are pretty stiff. Check out this RMD calculator from AARP.

More: Managing RMDs in a Down Market

What 401(k) Plans Offer

The 401(k) plan offers Americans a company-sponsored, tax-advantaged retirement plan during their working years.

With regular investments and matching contributions from employers, 401(k) holders can the best of both worlds – long-term investing opportunities on a tax-deferred basis and a tidy nest egg.