What is a 401(k)?

 
what is a 401(k)

What’s a 401(k), you ask? At its core, a 401(k) is an investment tool for retirement. It’s a type of plan called a “defined contribution plan.”

You put money into an account that is then invested in stocks, bonds, money market accounts and more. You work with a company – like Fidelity Investments or Vanguard – to select the mix of investments. This amount of money grows over time, and typically provides a better return than a traditional savings account. Once you retire, you can begin to withdraw funds from the 401(k) to support yourself.

Some common questions about 401(k) plans

Can you open your own 401(k) plan?

As an individual you can’t open up a plan.  401(k) plans are offered – or “sponsored” – by employers, unless you’re a small business owner, and in which that case you can open a solo 401(k).  Employers will often match a certain percentage of the amount you put into the plan (also called your “elective deferral”). Let’s say you send 4% of your salary to your 401(k). It’s possible that your employer may contribute additional money to this retirement account. It could be 1%, 2%, 3% or more. However, employers aren’t required to make this contribution, so the amount will vary widely. People often refer to this as “free money!”

If you’re employer doesn’t offer a 401(k) plan, there are many other defined contribution plans that are similar to them.

Employees at tax-exempt institutions may be able to participate in a 403(b) plan. Government employees could have a 457 plan, and federal civilian employees might have a Thrift Savings Plan. Your employer might offer a Roth 401(k), which is similar. The key difference is that with a Roth 401(k) plan income tax is paid at the time of investment, not when funds are withdrawn during retirement. The taxation of any distribution will depend on whether or not it is “qualified.”

If your employer doesn’t offer any of these plans you can start an individual retirement account (IRA), or Roth IRA. If you’re self-employed you can also start your own solo 401(k) if you have no employees or a SEP IRA if you have employees.

Is 401(k) pre tax?

Yes. The money invested in a 401(k) is deducted from your paycheck before taxes. However, it will be taxed when you withdraw money during retirement. The idea is that your tax rate in retirement will be lower than your current tax rate.

How much can you put in a 401(k)?

As of 2022, the maximum you can defer into your 401(k) is $20,500 per year unless you are age 50 or over. In that case, you can defer up to $27,000.

If you take money out of the account before you are 59.5 years old, you will typically incur a 10% penalty in addition to the regular income taxes you must pay.  So a 401(k) should definitely be considered a long-term savings strategy.

How much will my 401(k) grow?

The growth will depend on the market at large. Over time, the stock market shows very consistent growth, so this isn’t a risky strategy. However, there is no guaranteed return. You may grow your savings 2% or 12% in a given year. Just remember that, generally, over time these retirement accounts deliver better returns than a savings account.

Have questions about how retirement income

If you still have looming questions about taxes and investments, let H&R Block help. Our tax pros know the ins and outs of taxes and are dedicated to making sure you’ve filed with accuracy, so you get the biggest refund possible – guaranteed.

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