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A beginner’s guide to your 401(k)

Invest in your retirement while enjoying tax breaks and peace of mind.

A 401(k) can be a powerful retirement savings tool, but your plan may be downgraded by high fees and poor investment options. We’ll explain everything you need to know about 401(k)s and other retirement savings vehicles you may want to consider if yours is subpar.

What is a 401(k)?

A 401(k) is an employer-provided retirement savings and investing plan that offers tax benefits. You can build your 401(k) portfolio by picking from an investment menu that usually includes stocks, bonds and mutual funds.

To contribute to your 401(k), you set a percentage of your pay that you want to invest. Then, your employer automatically deducts that amount from each paycheck and invests it in your account.

Because your money flows from your check to your 401(k) before it’s taxed, it reduces your taxable income and can lower your tax bill each year. Some companies also match their employees’ contributions.

How is a 401(k) different from an IRA?

Table explaining the differences between 401(k)s and IRAs:

A 401(k) is similar to an individual retirement account (IRA). Anyone can open an IRA with a bank or brokerage, so you can opt for one if your company doesn’t offer a 401(k). But there are some key differences.

EnrollmentContribution limitsTax advantages
401(k)
  • Enrollment period and eligibility is set by the employer
  • Some automatically enroll eligible employees
  • $19,500
  • $25,500 if you’re 50 or older
  • Tax-deductible contributions
  • Investment earnings grow tax-free in your account
IRA
    You can enroll whenever you want
  • $6,000
  • $7,000 if you’re 50 or older
  • Tax-deductible contributions
  • Investment earnings grow tax-free in your account

Because 401(k) plans vary widely because of employer choices, you may want to consider saving in an IRA in addition to or instead of a 401(k). You can compare retirement account options here.

How does a 401(k) grow?

Your 401(k) grows based on the performance of the assets it invests in. But it also benefits from compound interest. This means interest that your account earns one year is built upon by future earnings.

With simple interest, your interest only builds on the initial deposit. So if you deposited $10,000 and you get an annual interest rate of 9%, it grows by $900 every year. After 30 years, it’ll be $12,700.

Now let’s see how $10,000 would grow in a 401(k). Let’s say your annual interest or rate of return is still 9%. After 30 years, your 401(k) balance would grow to $147,305. And that’s assuming you don’t contribute anything beyond that $10,000 balance.

Who manages a 401(k)?

A 401(k) is managed by a plan sponsor. This sponsor can be your company or a third-party benefits firm. Plan sponsors hire asset-management companies that handle investing matters.

Can I lose money in a 401(k)?

As with any investment, your 401(k) can lose money. The assets your 401(k) invests in may not perform well some years, thereby cutting your earnings.

But it’s important to think of a 401(k) as a long-term savings vehicle. Over time, markets recover from recessions and even crashes. In fact, the average stock market return for the last 50 years has been 10.9%.

Nonetheless, one of the best ways to protect your 401(k) from market downturns is to make sure it’s diversified. Diversifying your portfolio means investing in a variety of securities like stocks, bonds, exchange-traded funds (ETFs) and mutual funds.

Many 401(k) plans offer target-date funds (TDFs). These professionally-managed, diversified portfolios automatically shift their investment mix to safer assets, such as bonds and money market funds, as you get closer to retirement age. While not the perfect investment, TDFs can be great tools for those who would rather hand off investment decisions to the pros.

What does 401(k) stand for?

The 401(k) plan is named after a subsection in the Internal Revenue Code. It allows employers to create retirement savings plans to which employees can contribute portions of their wages before taxes. It also permits earnings on these contributions to grow tax-free until they’re withdrawn from the account.

Section 401(k) was added to the code in 1978. But the first 401(k) plan didn’t launch until 1981 when benefits consultant Ted Benna interpreted the code to create one for a client.

401(k) types

There are two main types of 401(k) plans offered by employers.

EligibilityContribution limits for 2021Tax advantages
Traditional 401(k)Determined by plan sponsor
  • $19,500
  • $26,000 if 50 or older
  • Tax-deductible contributions
  • Earnings grow tax-free in the plan
  • Withdrawals are taxed as part of ordinary income plus a 10% early withdrawal penalty if you’re under 59.5
Roth 401(k)Determined by plan sponsor
  • $19,500
  • $26,000 if 50 or older
  • Contributions can be withdrawn any time regardless of age
  • Earnings grow tax-free in the plan
  • Withdrawals are tax-free if you’re 59.5 or older and the account has been open for at least five years

It’s important to note that the above limits apply to all types of 401(k) accounts, which fall under the umbrella of defined contribution (DC) plans. So if you have a traditional and a Roth 401(k), your contribution limit is $19,500 across both plans.

Also, the contribution limits listed above represent employee contributions, also known as elective deferrals. Some companies offer employer matches. The maximum contribution from you and your employer is $58,000 or $64,500 if you’re 50 or older.

However, the IRS states that contributions from all sources can’t exceed 100% of your compensation.

See how your 401k saving compares

Lifecycle of a 401(k)

To make the most out of your 401(k), it may be helpful to think of the lifecycle of the 401(k), from its inception through your retirement.

Opening a 401(k)

Some companies auto-enroll their employees in their 401(k) plan. So follow the instructions on your plan documents or ask your HR department for these. Otherwise, it’s a pretty straightforward process.

    • Check with your HR department to see if you’re eligible. You may be eligible even if you’re working part time, thanks to the SECURE Act passed in 2019.
    • If you’re eligible, ask your HR department about next steps. You may need to fill out some paperwork or set up an account online. Keep some information at hand.
  • Legal name
  • Current address
  • Personal email address
  • Social Security number
  • Bank account information plus routing number to fund your 401(k) electronically
  • Decide how much to contribute to your 401(k). Experts recommend 15% of your pay, but even starting with 3% and gradually increasing can help.
  • Choose investment options. Look out for fees like expense ratios if you’re choosing ETFs or mutual funds. These funds invest in a variety of assets like stocks and bonds, so they’re a good way to get diversified from the start.

Contributing to a 401(k)

Before you get your paycheck, your employer automatically deducts an amount of your choosing to direct to your 401(k) plan if you choose to contribute. You can usually pick a dollar amount or a percentage of your pay.

How much of my salary can I contribute to my 401(k)?

You can contribute the lesser of 100% of your salary or the applicable contribution limits set by the IRS each year. For 2021, the 401(k) contribution limits are $19,500 or $26,000 if you’re 50 or older.

How 401(k)s are taxed

The taxation of 401(k)s generally depends on the type of plan and the age at which you withdraw money.

Withdrawing from a 401(k)

Withdrawing from your 401(k) often comes with complex rules, and doing so without incurring heavy penalties requires meeting certain age requirements.

  • Withdrawing from a traditional 401(k)
    • After 59.5: Withdrawals are considered part of your income, so these will be taxed at your federal tax-bracket rate. Some states will also tax your withdrawals. After age 72, you must take required minimum distributions (RMDs) based on the IRS Uniform Lifetime Table.
    • Before 59.5: Your withdrawals will be taxed as ordinary income plus a 10% early withdrawal penalty. The IRS also takes an automatic 20% early withdrawal withholding.
  • Withdrawing from a Roth 401(k)
    • After 59.5: You can withdraw contributions and earnings tax-free. You must take required minimum distributions (RMDs) from a Roth 401(k) when you reach age 72.
    • Before 59.5: You can withdraw your contributions tax-free. But earnings will be taxed as ordinary income plus a 10% tax penalty.

The good news is that for some needs you can borrow money from your 401(k) and avoid penalties. You can read the rules for 401(k) loans here.

Employer 401(k) contributions

Some companies offer employer matches. The rules for this vary across companies.

  • Full match: Your company may match 100% of your contributions up to 3% of your annual salary.So let’s say your annual salary is $40,000. Your employer would match your contributions dollar-for-dollar up to $1,200 (3% of $40,000).
  • Partial employer match: Your company may offer a 50% match on 401(k) contributions up to 6% of your annual salary. Let’s say your annual salary is $40,000. Your contributions eligible for matching would be $2,400. But because the company will match 50%, the most it can give is half of your contribution or $1,200.

4 alternatives to your employer’s 401(k)

If you find your 401(k) plan isn’t so hot, you have other options.

    • Traditional IRA: A traditional IRA is essentially a traditional 401(k) that’s not provided by an employer.

Key benefits:

  • More investment options
  • Lower fees in some cases
  • Option to shop around for the best IRA

Drawbacks:

  • No employer match
  • Much smaller contribution limits
    • Roth IRA: This works similarly to a Roth 401(k), but nearly anyone can open one through a bank or brokerage.

Key benefits:

  • Larger investment menu
  • Typically lower fees
  • No required minimum distributions

Drawbacks:

  • Income limits
  • No employer match
  • Smaller contribution limits
    • Health savings account: An HSA is a tax-advantaged savings and investing account designed to help you pay for medical expenses. But you can also use your HSA for retirement.

Key benefits:

  • Tax-deductible contributions
  • Money grows tax-free in the account
  • Withdrawals are tax-free for qualified medical expenses
  • Withdrawals for non-medical expenses are tax-free after age 65

Drawbacks:

  • You need a high-deductible health plan (HDHP) to open an HSA
  • Low contribution limits
    • Taxable brokerage account: This is your basic investing account.

Key benefits:

  • No contribution limits
  • Invest in virtually anything your brokerage offers

Drawbacks:

  • Earnings are taxed
  • Self-directed accounts can be difficult to manage for non-experienced investors

Withdrawing without penalty

You can withdraw from your 401(k) without penalty if you’re 59.5 or older. Early-withdrawal penalties on some hardship withdrawals may be waived if your plan allows these.

The rules vary by plan. But you can usually waive the penalty if you need the money to cover the following.

  • Medical expenses exceeding 7.5% of your adjusted gross income (AGI).
  • Court-ordered payments to a divorced spouse, a child or a dependent.
  • You lose your job at the age of 55 or later.
  • You become disabled.

Triggering events for a 401(k) plan

You can roll over a 401(k) when you experience a triggering event, also called a qualifying event. Your plan sponsor defines these events, but they’re usually the following.

  • Job termination: You were either discharged from your company or changed jobs.
  • Retirement age: You reached age 59.5.
  • Death: Your family or beneficiaries can receive the funds in either a lump sum or in installments, which could stagger the taxes on the withdrawals.
  • Disability: Your plan document would define disability.

4 options for triggering events

If a triggering event occurs in your life, you have a few options.

    1. Roll the assets into an IRA.

Pros

  • More investment options
  • Same tax benefits

Cons

  • May trigger a taxable event unless you do a direct trustee-to-trustee transfer
  • Depending on your plan’s vesting schedule, you may not keep all your employer matches
    1. Leave the assets in the existing 401(k).

Pros

  • Your money stays in a tax-advantaged account
  • Account keeps benefiting from investment earnings

Cons

  • May face higher fees
  • You can’t contribute to the plan
    1. Roll the assets into a new employer’s plan.

Pros

  • May find better investment options
  • Could see lower fees

Cons

  • The plan may not be as good as your previous one
  • It can be difficult to transfer funds out of the new plan unless you face a triggering event
    1. Cash out.

Pros

  • You can do whatever you want with the cash
  • Tax burden may be low depending on your age and income

Cons

  • May trigger severe tax consequences
  • You lose the benefits of compound interest
  • You eradicate your nest egg unless you have retirement funds elsewhere

Compare retirement accounts

These companies offer IRAs or offer help managing retirement accounts.

Name Product Minimum deposit to open Annual fee Available asset types
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$5
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ETFs
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$0
0%
Stocks, Options, ETFs
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$0
$0 per month
Stocks, Bonds, ETFs
Put your money to work. Let SoFi build and manage a portfolio for you. Pay zero SoFi management fees.
Betterment
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0.25% on balances up to $99,999

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ETFs
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Stocks, ETFs
Stash is more than an investment app. You’ll have access to tools that can help you become a confident investor.
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Disclaimer: The value of any investment can go up or down depending on news, trends and market conditions. We are not investment advisers, so do your own due diligence to understand the risks before you invest.

Bottom line

401(k) plans allow you to invest in your retirement while enjoying tax breaks. Your contributions are tax-deductible, and investment earnings grow tax-free. Some companies even offer matching contributions.

But the quality of 401(k) plans varies across companies. In some cases, an IRA may be a better option. You can open one with most brokerages, but be sure to compare your choices to find the one that’s right for you.

Frequently asked questions

401(k) plans can be as complex as they are beneficial. But here are some answers to common questions.

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