So many people have the question, what is a 401k?
Since its inception in 1978, the 401(k) plan has grown to become the most popular type of employer-sponsored retirement plan in America. Millions of workers depend on the money that they have invested in these plans to provide for them in their retirement years, and many employers see a 401(k) plan as a key benefit of the job. Few other plans can match the relative flexibility of the 401(k).
What is a 401k
A 401(k) plan is a retirement savings account that allows an employee to divert a portion of their salary into long-term investments. The employer may match the employee’s contribution up to a limit.
A 401(k) is technically a “qualified” retirement plan, meaning it is eligible for special tax benefits under IRS guidelines. Qualified plans come in two versions. They may be either defined-contribution or defined-benefit, such as a pension plan. The 401(k) plan is a defined-contribution plan.
That means that the available balance in the account is determined by the contributions made to the plan and the performance of the investments. The employee must make contributions to it. The employer may choose to match some portion of that contribution, or not. The investment earnings in a traditional 401(k) plan are not taxed until the employee withdraws that money, typically after retirement. After retirement, the account balance is entirely in the hands of the employee.
About half of employers make matching contributions to their plans, with an average of close to 3% of salary, according to data published by The Vanguard Group in 2019. Many match 50 cents on every dollar of the employee’s contribution, up to a limit. Some offer a varying contribution from year to year as a profit-sharing method.
A company that offers a 401(k) plan typically offers employees a choice of several investment options. The options are usually managed by a financial services advisory group such as The Vanguard Group or Fidelity Investments.
The employee can choose one or several funds to invest in. Most of the options are mutual funds, and they may include index funds, large-cap and small-cap funds, foreign funds, real estate funds, and bond funds. They usually range from aggressive growth funds to conservative income funds.
The distribution rules for 401(k) plans differ from those that apply to IRAs. In either case, an early withdrawal of assets from either type of plan will mean income taxes are due, and, with few exceptions, a 10% tax penalty will be levied on those younger than 59½.3
However, while an IRA withdrawal doesn’t require a rationale, a triggering event must be satisfied to receive a payout from a 401(k) plan.
The following are the usual triggering events:
- The employee retires from or leaves the job.
- The employee dies or is disabled.
- The employee reaches age 59½.
- The employee experiences a specific hardship as defined under the plan.
- The plan is terminated.