What is a 401(k) Employer-Sponsored Retirement Plan: How does it work?

401K plan

If you want to get ahead for retirement and work for a traditional employer, it may be a good idea to set up a 401(k) employer-sponsored retirement plan. A 401(k) plan lets you automatically put money into a secure investment account each month throughout your working years. This can make it easier to plan for retirement and ensure you can live comfortably throughout your retirement years.

401(k) plans come with several benefits, but they also have annual contribution limits for both you and your employer. Here’s everything you need to know about how a 401(k) plan works, as well as what makes it different from other retirement plans like the Roth 401(k).

How does a 401(k) work?

A 401(k) is a plan that lets you save and invest for retirement. They’re named after the 401(k) tax code and can grow significantly over time.

There are two main types of 401(k) plans: the traditional 401(k) and the Roth 401(k). They work similarly to each other, but the way they’re taxed differs.

With a traditional 401(k), your contributions are based on your gross income — that is, your income before taxes. This cuts down on your total taxable income for the year, based on how much you contribute. It also makes it where you don’t have to pay taxes on the amount in the account until you start withdrawing from it.

With a Roth 401(k), all employee contributions are based on your net income (income after taxes). This doesn’t reduce your taxable income for the year. However, any withdrawals will be tax-free.

To get a 401(k), you’ll need to work for a company that offers them. Once you’ve set one up, your employer will automatically withdraw a preset amount from your paycheck and invest the funds in an account you pick. Most people choose to invest in mutual funds, variable annuities, or stocks. You’ll also get to choose the percentage you want taken out of your paycheck. Depending, you may be able to change the contribution amount or stop contributing altogether.

Some companies offer contribution matching, meaning they’ll put in an equal amount into your 401(k) each month. Most employers do this each month, but some make a lump-sum payment at the end of the year. The employer’s contributions are essentially free money. So, if your company has this option, it may be worthwhile to take full advantage and maximize your contributions for your retirement years.

401(k) benefits include the ability to start saving and investing for retirement while still employed

401(k) benefits

401(k) plans come with several advantages, especially compared to other retirement accounts or traditional savings accounts.

  • Saving and investing for retirement: 401(k) plans are typically low-risk plans that help you reach your retirement goals. You get to choose the types of accounts you invest in and make contributions based on your income (within reason). The sooner you start investing, the more you can potentially save.
  • Tax benefits: With a 401(k), it’s possible to shield your earnings — or later withdrawals — from being taxed. The exact tax benefits depend on whether you choose a traditional or Roth 401(k).
  • Employer matching: Some employers match $0.50 for each dollar you contribute, while others match dollar-for-dollar (up to a certain salary percentage). Whatever the amount, employer matching means more money in your account at the end of the day. But if you leave the company within a certain period of time, you might lose the employer’s contribution (in some cases).
  • Account ownership: When you have a 401(k), you’re in control of your contributions and of the account. If you need to stop making contributions, you can do so. You can even withdraw from the account early, though you may have to pay an early withdrawal penalty. If you want to avoid a penalty, you may need to wait until you’re 59 ½ years old. If you haven’t started withdrawing from your 401(k) by the age of 72, you will need to start doing so.

401(k) annual contribution limits

There are 401(k) contributions limits that maximize how much you can invest in the account each year. The exact amount is mostly based on the current inflation rate, meaning it can change from one year to another. It’s also based on the employee’s age.

401(k) contribution limits are updated each year

For example:

  • 2022 annual contribution limit for employees under 50 years old: $20,500
  • 2022 annual contribution limit for employees over 50 years old: $27,000 (the extra $6,500 is considered a “catch-up contribution”)
  • 2023 annual contribution limit for employees under 50 years old: $22,500
  • 2023 annual contribution limit for employees over 50 years old: $30,000

If you have multiple 401(k) accounts, the total amount of your contributions cannot exceed the annual limit. This applies even if you have a traditional and a Roth 401(k) plan or have multiple employers within one year. You can, however, choose to split your contributions between accounts in any way you want.

It’s worth noting that employer contributions count differently from employer contributions.

For example:

  • 2022 combined total contribution limit for employees (under 50) and employers: $61,000
  • 2022 combined total contribution limit for employees (over 50) and employers: $66,000
  • 2023 combined total contribution limit for employees (under 50) and employers: $66,000
  • 2023 combined total contribution limit for employees (over 50) and employers: $73,500

401(k) contribution limits are updated each year, so it’s good to check what they are for the current year so you can increase your amount if needed.

Roth 401(k): How it’s different

Like a traditional 401(k), a Roth 401(k) is another type of savings and investment retirement plan. They’re also offered by employers. Participation in both cases is optional.

The biggest difference between the two is the way they’re taxed. While a traditional 401(k) is based on your pre-tax income, a Roth 401(k) is based on your after-tax income.

The IRS can only tax earned income once. So, since your Roth 401(k) contributions have already been taxed, you will not be taxed again when you ultimately withdraw from the account.

Both types of 401(k) plan protect your investments from the IRS. This means that you will not need to worry about your money being taxed as it grows. This goes for dividends, capital gains, and any interest that accrues in your account.

A Roth 401(k) plan has specific rules about withdrawals, though. Typically, you can only draw from your account once you reach the age of 59 ½ without a penalty. Exceptions do exist, such as if the account owner has a disability or passes away. If you need to withdraw early, make sure you won’t be penalized — or be aware of the penalty amount — first.

Not all employers offer Roth 401(k) plans. Some only offer a traditional plan, while others have both. Check what’s available, as well as if your employer offers contribution matching.

Traditional vs Roth 401(k) Contribution Limits

Roth 401(k) contribution limits are the same as the traditional 401(k) contribution limits. In 2023, the limit is $22,500 for those under the age of 50. For those over the age of 50, the limit is $30,000 (due to the $7,500 “catch-up” amount).

If you have two 401(k) plans — a traditional and a Roth account —, you may contribute across both accounts. However, you will still have to follow the yearly contribution limits.

In rare cases, someone might exceed the contribution limit. If this happens, you may receive a penalty and the excess funds will be removed. If you exceed the amount by accident, you may be able to avoid any further penalty.

It’s ultimately up to you — and the tax breaks you want — how you choose to contribute. For example, if you want a greater tax deduction during your working years, you might prefer the traditional 401(k). But if you predict you’ll end up in a higher tax bracket when you retire, it may be better to choose a Roth 401(k).

The sooner you start investing, the more you can potentially save

Conclusion

Preparing for retirement can be challenging, especially with the uncertainty that comes with an ever-changing economy. With an employer-sponsored retirement plan like a 401(k), you can start saving and investing now to get ahead of the game.

There are two main types of 401(k) retirement plans: traditional and Roth. Choose the one that best suits your needs and financial situation. Consider the contribution limits and tax benefits to each before selecting one.

If your employer offers contribution matching (even if it’s not 100%), try to take advantage of that. And, if you decide to change jobs while you have a 401(k), be sure to bring your account with you.

Angela Mae Watson Angela Mae Watson Last update:
Angela Mae is a personal finance writer specializing in loans, debt management, investing, retirement planning, and financial literacy. She comes from a journalistic background and pulls from hands-on experience and deep-dive research to breathe life into her stories. Her goal is to help others achieve financial stability and independence. When not writing, she can be found traveling, honing her yoga skills, hiking, or exploring new means of healthy, sustainable living.