401(K) PLAN: THE COMPLETE GUIDE

What Is a 401(k) Plan?

A 401(k) plan is a tax-advantaged, defined-contribution retirement account offered by
many employers to their employees. It is named after a section of the U.S. Internal Revenue
Code. Workers can make contributions to their 401(k) accounts through automatic payroll
withholding. And their employers can match some or all of those contributions. The
investment earnings in a traditional 401(k) plan are not taxed until the employee
withdraws that money, typically after retirement. In a Roth 401(k) plan, withdrawals can
be tax-free.1

KEY TAKEAWAYS
A 401(k) plan is a company-sponsored retirement account that employees can contribute
to. Employers may also make matching contributions.
There are two basic types of 401(k)s—traditional and Roth—which differ primarily in how
they’re taxed.
In a traditional 401(k), employee contributions reduce their income taxes for the year they
are made. But their withdrawals are taxed. With a Roth, employees make contributions
with post-tax income but can make withdrawals tax-free.
For 2022, under the CARES Act, withdrawal rules and amounts were relaxed for those
affected by COVID-19. And RMDs were suspended.
Understanding 401(k) Plans
There are two basic types of 401(k) accounts: traditional 401(k)s and Roth 401(k)s.
Sometimes referred to as a “designated Roth account.” The two are similar in many
respects. But they are taxed in different ways. A worker can have either type of account or
both types.

Contributing to a 401(k) Plan

A 401(k) is what’s known as a defined-contribution plan. The employee and employer can
make contributions to the account, up to the dollar limits set by the Internal Revenue
Service (IRS). By contrast, traditional pensions [not to be confused with traditional
401(k)s] are referred to as defined-benefit plans—the employer is responsible for providing
a specific amount of money to the employee upon retirement.2

In recent decades, 401(k) plans have become more plentiful and traditional pensions
increasingly rare, as employers have shifted the responsibility and risk of saving for
retirement to their employees

ALSO
Employees are responsible for choosing the specific investments within their 401(k)
accounts, from the selection their employer offers. Those offerings typically include an
assortment of stock and bond mutual funds as well as target-date funds that hold a mixture
of stocks and bonds appropriate in terms of risk for when that person expects to retire.
They may also include guaranteed investment contracts (GICs) issued by insurance
companies and sometimes the employer’s own stock.

Contribution Limits
The maximum amount that an employee or employer can contribute to a 401(k) plan is
adjusted periodically to account for inflation. As of 2021 and in 2022, the basic limits on
employee contributions are $19,500 per year for workers under age 50 and $26,000 for
those 50 and up (including the $6,500 catch-up contribution).

If the employer also contributes—or if the employee elects to make additional, non-
deductible after-tax contributions to their traditional 401(k) account (if allowed by their
plan)—the total employee/employer contribution for workers under 50 for 2022 is capped
at $58,000, or 100% of employee compensation, whichever is lower. For those 50 and over,
again for 2022, the limit is $64,500.3

Employer Matchin
Employers who match their employee contributions use different formulas to calculate that
match. A common example might be 50 cents or $1 for every dollar the employee
contributes up to a certain percentage of salary. Financial advisors often recommend that
employees try to contribute at least enough money to their 401(k) plans each to get the full
employer match.

Contributing to a Traditional and Roth 401(k)

If they wish—and if their employer offers both choices—employees can split their
contributions, putting some money into a traditional 401(k) and some into a Roth 401(k).
However, their total contribution to the two types of accounts can’t exceed the limit for one
account (such as $19,500 (if you are under age 50) in 2021 and 2022).1

Employer contributions can only go into a traditional 401(k) account—not a Roth—where

they will be subject to tax upon withdrawal.
Taking Withdrawals from a 401(k)
Participants should remember that once their money is in a 401(k), it may be hard to
withdraw without penalty.

“Make sure that you still save enough on the outside for emergencies and expenses you may
have before retirement,” says Dan Stewart, CFA®, president of Revere Asset Management
Inc., in Dallas, Texas. “Do not put all of your savings into your 401(k) where you cannot
easily access it, if necessary.”
FURTHERMORE
The earnings in a 401(k) account are tax-deferred in the case of traditional 401(k)s and tax-
free in the case of Roths. When the owner of a traditional 401(k) makes withdrawals, that
money (which has never been taxed) will be taxed as ordinary income. Roth account
owners (who have already paid income tax on the money they contributed to the plan) will
owe no tax on their withdrawals, as long as they satisfy certain requirements.4

Both traditional and Roth 401(k) owners must be at least age 59½—or meet other criteria
spelled out by the IRS, such as being totally and permanently disabled—when they start to
make withdrawals. Otherwise, they usually will face an additional 10% early-distribution
penalty tax on top of any other tax they owe.5

Special Changes in 2022

The $2 trillion coronavirus emergency stimulus bill that was signed into law allows those
affected by the coronavirus pandemic a hardship distribution up to $100,000 without the
10% early distribution penalty those younger than 59½ normally owe. Account owners also
have three years to pay the tax owed on withdrawals, instead of owing it to the IRS in the
current year.6

This hardship provision must be adopted by the plan so it’s best to check with your plan
administrator first, or they can repay the withdrawal to a 401(k) or IRA and avoid owing
any tax—even if the amount exceeds the annual contribution limit for that type of account.

Required Minimum Distribution

Both types of accounts are also subject to required minimum distributions, or RMDs.
(Withdrawals are often referred to as “distributions” in IRS parlance.) After age 72,
account owners must withdraw at least a specified percentage from their 401(k) plans.
Using IRS tables based on their life expectancy at the time (prior to 2021, the RMD age had
been 70½ years old).

If they are still working and the account is with their current employer, however. They may
not have to take RMDs from that plan.7

Note that distributions from a traditional 401(k) are taxable. Qualified withdrawals from a
Roth 401(k) are not. But they do lose the tax-free growth of being within the 401(k)
account.

Special Changes in 2022

The coronavirus stimulus package, known as the CARES Act, suspended RMDs from
retirement accounts in 2022. This gives those accounts more time to recover from the stock
market downturns. And retirees who can afford to leave them alone get the tax break of
not being taxed on mandatory withdrawals.

Roth IRAs, unlike Roth 401(k)s, are not subject to RMDs during the owner’s lifetime.

Traditional 401(k) vs. Roth 401(k)

When 401(k) plans first became available in 1978, companies and their employees had just
one choice: the traditional 401(k). Then, in 2006, Roth 401(k)s arrived. Roths are named
for former U.S. Senator William Roth of Delaware, the primary sponsor of the 1997
legislation that made the Roth IRA possible.8

While Roth 401(k)s were a little slow to catch on, many employers now offer them. So the
first decision employees often have to make is between Roth and traditional.

As a general rule, employees who expect to be in a lower marginal tax bracket after they
retire might want to opt for a traditional 401(k). And take advantage of the immediate tax
break. On the other hand, employees who expect to be in a higher bracket might opt for the
Roth so that they can avoid taxes later. For example, a Roth might be the right choice for a
younger worker. Whose salary is relatively low now but likely to rise substantially over
time.

Also important—
especially if the Roth has years to grow—is that there is no tax on withdrawals. This means
that all the money the contributions earn over decades of being in the account is also not
taxed.

Since no one can predict what tax rates will be decades from now, neither type of 401(k) is
a sure thing. For that reason many financial advisors suggest that people hedge their bets,
putting some of their money into each.

1:57

Introduction To The 401(K)

Special Considerations: When You Leave Your Job
When an employee leaves a company where they have a 401(k) plan, they generally have
four options:

1. Withdraw the money

This is usually a bad idea unless the employee absolutely needs the cash for an urgent
purpose. Such as a medical bill. Not only will the money be taxable in the year it’s
withdrawn. But the employee may also be hit with the additional 10% early distribution
tax unless they are over 59½. Totally and permanently disabled, or meet the other IRS
criteria for an exception to rule 5. This rule has been suspended for 2022 for those affected
by the COVID-19 pandemic, as noted above.

In the case of Roth IRAs, the employee’s contributions may be withdrawn tax-free and
without penalty at any time, but earnings will be taxable if the employee is under 59½ and
has had the account for less than five years.9 And even if the employee is able to withdraw
the money tax-free, they will be diminishing their retirement savings, which they may
regret later in life.

2. Roll it over into an IR

By moving the money into an IRA at, say, a brokerage firm or mutual fund company, the
employee can avoid immediate taxes and maintain their account’s tax-advantaged status.
What’s more, the employee is likely to have a wider range of investment choices in an IRA
than with their employer’s plan.10

The IRS has relatively strict rules on rollovers and how they need to be accomplished, and
running afoul of them can be costly. Typically, the financial institution that is in line to
receive the money will be more than happy to help with the process and avoid any missteps.

Funds withdrawn from your 401(k) must be rolled over to another retirement account
within 60 days to avoid taxes and penalties.

3. Leave it with the old employer

In many cases, employers will permit a departing employee to keep a 401(k) account in
their old plan indefinitely, although the employee can’t make any further contributions to
it. This generally applies to accounts worth at least $5,000—in the case of smaller accounts,
the employer may give the employee no choice but to move the money elsewhere.

Leaving 401(k) money where it is can make sense if the old employer’s plan is well
managed, and the employee is satisfied with the investment choices it offers. The danger is
that employees who change jobs over the course of their careers can leave a trail of old
401(k) plans and may forget about one or more of them. Their heirs might also be unaware
of the existence of the accounts.

4. Move it to a new employer

Some companies allow new employees to move an old 401(k) into their own plan. As with
an IRA rollover, this can maintain the account’s tax-deferred status and avoid immediate
taxes. It could be a wise move if the employee isn’t comfortable with making the investment
decisions involved in managing a rollover IRA and would rather leave some of that work to
the new plan’s administrator.10

In addition, if the employee is nearing age 72, note that money that is in a 401(k) at one’s
current employer is not subject to RMDs. Moving the money will protect more retirement
assets under that umbrella.7

ARTICLE SOURCES
Related Terms

What Is a Traditional IRA?

A traditional IRA (individual retirement account) allows individuals to direct pre-tax

income toward investments that can grow tax-deferred. more
Individual Retirement Account (IRA)
An individual retirement account (IRA) is an investing tool individuals use to earn and
earmark funds for retirement savings. more

The Complete Guide to the Roth IRA

A Roth IRA is a retirement savings account that allows you to withdraw your money tax-
free. Learn why a Roth IRA may be a better choice than a traditional IRA for some
retirement savers. more
403(b) Plan
A 403(b) plan is similar to a 401(k) but is designed for certain employees of public schools.
Mnd tax-exempt organizations among other differences. more

Roth Option

A Roth option, is available in some company 401(k) retirement plans. Permits an employee
to contribute after-tax dollars to an account. more

Qualified Distribution

A qualified distribution is a withdrawal that is made from an eligible retirement account

and is tax- and penalty-free. more
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