A 401(k) is a tax-deferred investment account, sponsored by an employer.
Some plans may allow for Roth (post-tax) deferrals to allow tax-free withdrawals in the future, subject to certain requirements.
There are two primary advantages to having a 401(k)--receiving an employer contribution (if offered, which is “free money” for retirement savings), and tax benefits.
What is a 401(k), and why is it so special?
A 401(k) is a tax-deferred investment account that allows employees to contribute a percentage of their salary to be saved for retirement. The money an employee puts away into an account is an investment in the market, made up of mutual funds, stocks, bonds, money market funds, savings accounts, and other investment options.1 It is subject to investment risk, meaning it can gain or lose value based on one’s investment choices.
The purpose of a 401(k) plan is to ensure that people can save for retirement. Unfortunately, saving for retirement seems to be an issue for most Americans. According to research published by Jack VanDerhei, which was referenced in Deloitte, there's a $3.68 trillion deficit in retirement savings. While there are many contributing factors that can prevent someone from having enough money to save for retirement, a 401(k) account is designed to encourage people to save as much as they can.
A 401(k) plan must be sponsored by an employer because these tax-deferred plans are specifically set up to help businesses encourage their employees to save for retirement. While employees are the participants in the plan, they cannot set up a 401(k) plan of their own (unless they sponsor a Solo(k) as a self-employed individual).
Why is my employer offering a 401(k)?
A 401(k) is attractive to employers for several reasons, which we’ve outlined below:
Employees can benefit from the tax advantages of a 401(k) – and so do employers.
The IRS gives eligible employers tax credits for starting a 401(k) plan and/or tax deductions if an employer contributes to their employee’s 401(k)s.
Employers can increase their chances of hiring and retaining talent. According to a Human Interest study, a retirement plan is the second most wanted benefit after health insurance.
What are the benefits of a 401(k)?
The primary benefit of a 401(k) plan is to help employees save for retirement. However, there are two additional benefits that entice employees to contribute to a 401(k): potentially receiving a contribution from an employer, and reducing taxable income for the year.
When an employer chooses to contribute a match or profit-sharing contribution to their employee’s 401(k) accounts, a match is given to employees who defer into the plan, and is calculated based upon the amount an employee defers into the plan from their paycheck.
Matching contribution example
An employee contributes $5,000 (or 5% of their salary) to their 401(k) account, and their employer matches $0.50 per dollar on the first 5% an employee defers. The employee would receive $2,500 ($5,000 x 50%) in matching funds, just for deferring into the plan. Now, the employee has $7,500 in total contributions for the year.
A profit-sharing contribution does not require an employee to defer into the plan to receive the contribution, but there could be other requirements set forth by the plan document that the employee must meet annually to receive the contribution, such as employment on the last day of the plan year.
The second benefit is the reduction of taxable income in the year of deferral. Traditional (pre-tax) deferrals are deducted before income taxes are withheld from pay, and are taxed upon withdrawal (which is usually later in life). This could result in significant tax savings at year-end.
Taxable income example
Let’s look at a quick example to illustrate the benefits of contributing to a 401(k) plan. A participant earns $100,000 per year. They are 27 years old, single, have no dependents, and will be taking the standard deduction of $13,850 for 2023.*
|Without Deferrals||With Deferrals|
|401(k) Deferrals (pre-tax)||$0||$22,500|
|Estimated Federal Tax||$14,261||$9,311|
The immediate tax benefit of contributing the maximum amount allowed by law to a 401(k) in 2023 is an estimated 50.76% in tax savings—or $4,950.
*According to the IRS, the standard deduction for single taxpayers and married individuals filing separately is $13,850 for taxable years starting in 2023. In calculating this example, this standard deduction is subtracted from the hypothetical annual gross pay of $100,000 for a total of $63,650 taxable income. Based on taxable income and filing status—and with zero 401(k) contributions—it’s estimated that our hypothetical employee will be taxed at a 16.6% effective tax rate for a total of $14,260. When 401(k) contributions are increased to $22,500, our hypothetical employee’s taxable income decreases to $63,650, their effective tax rate decreases to 14.6%, and their total estimated federal tax due decreases to $9,311.
How does a 401(k) work?
401(k)s are defined contribution plans. This means that employers create a retirement plan which allows employees to contribute money (otherwise known as a deferral) on a pre-tax basis up to a limit set by the IRS. The money that is deposited into an employee’s account is then invested into their investment elections.
What is the contribution limit for 401(k)s?
For 2023, the maximum deferral contribution limit as set forth by the IRS is $22,500. The catch-up contribution limit for those participants who will be 50 years or older in the calendar year is $7,500 for 2023. These limits change annually depending on COLA adjustments.
|Under 50 years old||50 years old or older|
What types of 401(k) deferrals are there?
There are two types of deferrals allowed in 401(k) plans. Traditional, or pre-tax, and Roth, or post-tax deferrals. Roth deferrals are not a required 401(k) plan provision, but most employers give the option to contribute them into the plan.
|Roth 401(k)||Taxed||Tax-free||Tax-free, if certain requirements are met|
If you have trouble choosing between the two types of deferrals, you may want to consider two points:
A traditional 401(k) deferral may be best if you expect your tax bracket will be lower when you retire. If so, your withdrawals at retirement will be subject to a lower tax bracket when withdrawn.
A Roth 401(k) deferral may be best if you expect your tax bracket will be higher when you retire. Assuming this to be the case, your withdrawals at retirement will be tax free, and would have been taxed at the lower rate assessed when originally deferred into the plan.
You can work with a financial advisor to forecast whether you expect to be in a lower or higher tax bracket during retirement to make an informed decision on what type of 401(k) deferral is right for you.
Remember that tax rates could rise in the future and, even if they don't, it is nice to have some money in retirement that has already been taxed. A Roth 401(k) can be a sensible choice for high-income earners seeking a post-tax retirement savings tool. However, for higher earners, the only way to access a Roth contribution may be through an employer-based plan since Roth individual retirement accounts (Roth IRAs) have contribution limits based on income.
401(k) features: auto-enrollment, auto-escalation, vesting schedules
Every 401(k) plan may come with different features depending on your employer. Here are a few of the most common features of 401(k) plans.
1. Automatic enrollment
Automatic enrollment allows an employer to sign an employee up to participate in the company’s 401(k) plan unless they choose to opt-out. Newly eligible employees who don’t opt out of plan participation will have a default percentage of compensation contributed pre-tax to their plan from each paycheck. Employers set the default election in the plan document. The plan sponsor or 401(k) custodian can be contacted to opt-out of the automatic enrollment process or to change a deferral election.
Auto-escalation refers to a plan provision where an employee’s deferral election is increased on a regular basis, usually annually in 1% increments. The plan sponsor or 401(k) custodian can be contacted to opt-out of the automatic escalation process or to change a deferral election.
3. Vesting schedule
A vesting schedule establishes what percentages of employer contributions an employee owns as they continue employment with the plan sponsor. Even though the employer may make contributions during a specific pay period, many employers offer vesting schedules to incentivize longer-term employment by offering partial ownership over time. There are three types of vesting schedules, and each type and rate varies by employer:
Immediate vesting: Employees own 100% of the employer matching contributions immediately.
Graded vesting: Employees own a growing percentage of employer 401(k) contributions over time. For example, an employee may own 25% of an employer's matching contributions after one year of employment, 50% after two years, and so on. Employers must provide for vesting of at least 20% of the contributions by the end of two years and 100% by the end of six years.
Cliff vesting: Under this schedule, employers must fully vest their employees by the end of three years of employment, and there are no progressive levels of vesting.
Vesting schedules must be clearly explained in the employer’s 401(k) plan document. Click here to learn more about 401(k) vesting schedules.
How much do people put in their 401(k) per year?
According to Vanguard’s 2022 How America Saves report, which uses data from 5 million Vanguard participants, the median deferral rate is 6.1% and the median balance in a 401(k) account is $35,245.
Do most people get an employer match?
Yes–according to a Plan Council of America Survey, 98% of 401(k) plans offer an employer match or a profit-sharing contribution.
What's the typical vesting schedule for an employer match?
Vanguard’s 2022 How America Saves report found that most retirement plans, Vanguard administers, do not immediately vest participants in employer matching contributions. Of the plans with employer matching contributions and a vesting schedule, a quarter used a five or six year graded vesting schedule.
What's the average 401(k) balance?
According to Vanguard’s 2022 How America Saves report, the average 401(k) balance is $141,542. While this may seem like a large sum of money, an analysis by Northwestern Mutual found that the typical American expects they’ll need $1.25 million for a comfortable retirement.
Does my employer have to match?
A matching contribution from your employer is not required. That said, many employers do offer a match, and they also choose the formula that will determine how much they contribute to your 401(k) plan.
Limits for high-income earners
As determined by the IRS, employees whose annual income or percentage ownership in the company meets a specific threshold may only contribute a portion of their earnings. If you own 5% or more of the business offering the 401(k) plan or are a family member of someone who does, or earn over $150,000 in 2023, you may be subject to a refund depending on non-discrimination testing results each year.
If you also plan to contribute to an IRA
If you have access to an employer-sponsored retirement savings plan, such as a 401(k), your modified adjusted gross income will determine how much - if any - of a tax deduction you’ll get for IRA contributions.
401(k) and special circumstances
There are many times when you may have special circumstances regarding a 401(k). Let’s review some of those below.
You change jobs
If you decide to work for a new employer, you have a few options regarding what you can do with your 401(k). Assuming you’re not 59 ½ or ready to withdraw, you can choose to roll over your 401(k) into a new account (if applicable) or IRA. You can also decide to leave it with your former employer if it exceeds the cashout limit of the plan (either $1,000 or $5,000)
You have multiple 401(k)s
Having multiple 401(k) accounts is allowed, even concurrently contributing to more than one, as long as you don’t exceed the annual deferral contribution limit (you will also need to be employed by multiple companies if you plan on contributing to more than one plan).
You need the money before retirement
Since a 401(k) is a retirement account, the rules make it hard to take money out before age 59 ½. It’s important to note that if you take out money before age 59 ½, you may be taxed on your total cash distribution and have to pay a 10% early withdrawal penalty based upon the gross amount if it doesn’t qualify for an exception. However, you can technically withdraw money in what is known as a hardship distribution.
A hardship distribution is when an individual withdraws money from their retirement account due to severe financial hardship or burden. Hardship distributions are subject to income tax plus additional tax.
You go through a divorce
A 401(k) typically comes up during divorce proceedings. In many cases, couples going through a divorce split the 401(k), and this requires preparing a Qualified Domestic Relations Order (QDRO). The QDRO is required in order to assign benefits from a participant to an alternate payee.
You pass away
Having a beneficiary associated with your 401(k) can help ensure that the funds are directed where you want them to go in the event of your death. Otherwise, you risk having them rolled into the rest of your estate.
If you’re married and pass away, ERISA regulations require that your spouse* be the beneficiary of your 401(k) unless their consent is on file.
Article ByThe Human Interest Team
We believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment education, and integration with leading payroll providers.