Does your employer offer a 401(k) retirement plan as an employee benefit? If so, you’ll want to know how these plans work, what happens if you leave your job, and how you can get your money out of the plan. Here are the basics.
Section 401(k) of the Internal Revenue Code permits employers to set up a trust fund to which an employee may elect to have pretax amounts of the employee's salary contributed to the trust under the plan instead of receiving the amount of salary in cash in order to save for retirement.
What Is a 401(k) Plan?
Section 401(k) of the Internal Revenue Code permits (but does not require) employers to set up a retirement savings plan for employees. Employees have the option to either receive all of the compensation they have earned or ask the employer to put a percentage or specific dollar amount of their earnings into a 401(k) plan (if available). Typically, contributions to a 401(k) plan are pretax, which means you don’t pay income tax on that money when you earn it and place it into the account.
Your employer’s 401(k) plan will likely offer you a choice of investment options for your money, often mutual funds. If your investments grow in value and earn money, you won’t have to pay tax right away on those gains. Instead, like the money you put into the account, you will owe money on earnings only when you withdraw them from the 401(k).
What are the Benefits to Participating in a 401(k) Plan?
There are two main advantages to participating in your employer’s 401(k) plan. First, as mentioned above, the amounts you contribute do not count as taxable income to you. This means your earnings for the year will be reduced by the amount you contribute, and your income taxes will decrease accordingly. Your investments will grow tax-free until you begin taking withdrawals. And, even then, you will owe tax only on the amount you take out of the account.
Second, many employers offer a 401(k) match. In this type of plan, the employer also deposits money into each employee’s 401(k) retirement account, in an amount equal to the employee’s contribution (up to a set limit). For example, an employer might offer to match employee contributions up to $3,000 per year. If your employer offers a 401(k) match, you should absolutely take advantage of it. This is essentially free money, which you don’t want to leave on the table! Employers can deduct these contributions at tax time.
How Much Can You Contribute?
You may defer up to $19,000 a year, tax-free, to your employer’s 401(k) account. (This amount is for 2019; the limit changes from time to time to adjust for inflation.) If you put more than this in your account, you will have to pay income tax on it twice, once in the year you pay it and again when you withdraw the money. There may be other consequences to making an excess deferral: Talk to your plan administrator to find out the rules.
If you are at least 50 years old by the end of the year, you may also make a “catch-up” contribution of an additional $6,000 (again, this is the amount for 2019). To find out more about contribution amounts, excess deferrals, and more, check out the IRS’s 401(k) Contribution Limits page.
What Vesting Rules Apply to 401(k) Plan Contributions?
The money you contribute to your 401(k) account belongs to you. You may withdraw it at any time, subject to taxes and possible penalties for early withdrawals. Your employer may not adopt a vesting schedule that places your own contributions to the account off-limits for a period of time. This rule also applies to any amounts earned on the money you have contributed to the 401(k) account.
However, employer contributions to your 401(k) plan are treated differently. Your employer is free to adopt a vesting schedule for these amounts (and their earnings), by which this money belongs to you only after a certain number of years of service with the company. For example, a plan might provide that you are vested in 25% of your employer’s contributions to the plan after you have contributed to the plan for two years, and an additional 25% for every year after that.
When Can You Withdraw Money Without Penalties?
You may begin taking distributions without penalty from your 401(k) account when you reach the age of 59 ½. If you take money out of your account before you have reached this age, you will have to pay income tax on that amount, plus a 10% tax penalty, unless an exception to the usual rule applies. For example, you may take a “hardship distribution” from your plan, without paying the penalty, if necessary to manage an immediate, heavy financial need. Find out more about the withdrawal rules and exceptions at the IRS’s page on 401(k) distributions.
More Information on 401(k) Plans
Employers who offer 401(k) plans must provide their employees with lots of information on plan options and rules. For additional information, including details on the different types of 401(k) plans, see the U.S. Department of Labor's 401(k) Plans for Small Businesses.