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What is a 401(k) plan, and how does it work?


By The Human Interest Team

Editorial Policy

A 401(k) is one of the most commonly used – and powerful – tools to help you save for retirement. In this guide, we’ll walk through what it is and how it works. 

What is a 401(k)? 

In short: A 401(k) is a retirement investment account that you can get through work. A 401(k) allows employees to set aside a percentage of their salary for retirement and get tax benefits for doing so. 

What else should I know? 

  • Roughly 60 million people actively contribute to a 401(k). 

  • Historically, small and medium-sized businesses have been less likely to offer one. At Human Interest, we’re helping to change that by making it easier and more affordable for businesses and their employees.

  • 401(k)s have been around for more than 40 years and get their name from the section of the IRS code where they were first introduced: Section 401(k).

Why is my employer offering a 401(k)?

A 401(k) is attractive to both employees and employers. 88% of employees say a 401(k) is a must-have when looking for a job, so one of the primary reasons companies offer 401(k) plans is to attract and retain top talent. Employees also benefit from the tax advantages of a 401(k) – and so do employers. Just like employees, employers get tax advantages from contributions they put into a 401(k). The IRS also gives employers tax credits for starting up and offering a 401(k) plan to their employees.

What are the benefits of a 401(k)?

By using a 401(k) to save for retirement, you’re getting benefits both today and tomorrow, including:

  • Investing – even automating investing – for retirement 

  • Tax-advantages today, like reducing your taxable income

  • Tax-free or tax-deferred growth on investments in your account

  • The chance to invest in the stock market

  • High contribution limit vs. other types of retirement accounts (meaning you can get bigger tax advantages and save more money)

  • Being able to make catch-up contributions to accelerate retirement savings (larger than any other kind of retirement savings account)

  • And, if your employer offers a match, you can get ‘free money’

But first, how does a 401(k) work?

Every pay period:

Because we sync with many employers’ payroll systems, you can easily choose how much money you want to set aside, or contribute to your account, each pay period. You can also change or update that amount as often as you like. Any money you contribute to your 401(k) will be deposited into your own account where you can choose how it is invested, and your investments will grow when the market grows. 

At tax time:

The total amount of money that you contribute to your 401(k) is automatically tabulated by Human Interest. You’ll receive a tax benefit for your 401(k) contributions, which could lower your taxable income. 

When you leave your employer:

Every year, millions of people change jobs. If you leave a job, you may be able to keep your 401(k) open, but you won’t be able to keep contributing to that account. Read our guide to 401(k)s and job changes to learn more about your options. 

At retirement:

At age 59 ½ you can start taking money out of your account. By age 72, the IRS will require you to start taking a certain amount of money out of your 401(k) each year.

How much can I save in a 401(k)?  

The maximum you can contribute depends on your age as well as whether you’re an employee or a business owner. While the IRS can set a new 401(k) contribution limit every year, there was no increase for 2022. 

Annual contribution limit

In 2022, the maximum contribution you can make is:

If you'reAge < 50Age 50+
An employee $20,500 + employer match*$27,000 + employer match*
A business owner (with employees)$61,000 or up to 25% of net earnings, whichever is less + employer match$67,500 or up to 25% of net earnings, whichever is less + employer match

How is the annual contribution limit affected by an employer match? 

If your employer provides a matching contribution, that does NOT count against the $20,500 contribution limit, i.e., you can contribute $20,500 and your employer contributions will be in addition to that. 

Between your contributions AND your employer match, the total amount that can enter into your 401(k) in 2020 is $57,000 ($61,000 in 2022), provided you’re under 50 years of age. If you’re age 50 or older, that limit is $63,500 in 2020 and $64,500 in 2022.

If I have more than one 401(k), can I put $20,500 into each? 

No, $20,500 is the total you can put away in a single year, no matter how many accounts. If you change employers in the middle of the year, or work two jobs that both offer a 401(k), you must stick to the annual contribution limit of $20,500.

Does my employer have to match? 

No, a matching contribution from your employer is NOT required. That said, many employers do offer a match and they choose the formula that will determine how much they contribute. The most common matching formula is $0.50 per dollar on the first 6% of pay. 

Maxing out your employer match

Here’s what that matching formula looks like for someone earning $50,000 and contributing between 2-10% of their pay.

Your contribution$1,000$1,500$2,000$2,500$3,000$5,000
Employer contribution$500$750$1,000$1,250$1,500$1,500

One strategy for investing in your 401(k) is contributing the amount you need in order to get the most you can from your employer, or to “max out your employer match”. In the example above, the employer will pay $0.50 per dollar on the first 6% of pay. 

  • 6% of $50,000 is $3,000 

  • And an employer will pay 50% of that, so $1,500

In this example, the saver will “max out their employer match” by contributing $3,000. If they prefer, they could contribute more than that (since they’ll only have contributed $3,000 vs. the annual contribution limit is $20,500). They could get additional tax benefits for contributing more than $3,000 but, in this case, contributing more would not result in any additional matching contribution beyond what’s specified in the formula.

Reminder: the employer match isn’t included in the $20,500. Keep reading to see below how much people contribute to their 401(k) on average.

What types of 401(k)s are there? 

There are two types of 401(k) accounts: a traditional 401(k) and a Roth 401(k). There are many similarities between the two types as well as a few key differences to know about -- chiefly when they are taxed. 

Traditional vs. Roth 401(k)s differ in when they are taxed: 

Contributions (how your money goes in)Investments grow...Distributions(how your money comes out)
Traditional 401(k)Tax-freeTax-freeTaxed
Roth 401(k)TaxedTax-freeTax-free

Many employers give the option of whether you use a traditional vs. a Roth 401(k)—some even allow you to use both at the same time. You’ll need to decide which type is best for you. If you choose to contribute to both, the limit is $20,500 between both. 

Many people make this decision by figuring out whether they’re in a lower or higher tax bracket now compared to where they expect to be in retirement. Typically, people who are earlier in their career and expect to earn more in the future are in a lower tax bracket now, which means a Roth 401(k) could be a good idea. Individuals who are more established in their career or in their peak-earning years might be better off with a traditional 401(k). Here’s a summary: 

  • A traditional 401(k) is best if: You’re a high earner whose tax bracket is probably higher than it will be when you retire. Reducing your taxable income by the amount of your contribution would put you in a lower tax bracket.

  • A Roth 401(k) is best if: You’re a low earner whose tax bracket will probably be lower when you retire. You think that policy changes will make tax rates overall much higher when you retire – for example, you predict that the same income taxed at 20% today will be taxed at 40% when it’s time for you to retire.

Frequently asked questions: Roth 401(k)s

Are Roth 401(k)s only if you have a lower income?

  • No. 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.

Are Roth 401(k)s subject to income restrictions like Roth IRAs?*

  • No, a Roth 401(k) is a good option for high-income earners seeking a post-tax retirement savings tool. For these higher earners, the only way to access a Roth may be through an employer-based plan since Roth IRAs have contribution limits based on income.

*Roth IRA Income limits: You can only contribute to a Roth account if you fall below certain income levels. For 2022, your modified adjusted gross income must be less than $208,000, if married; less than $140,000, if single. For 2020, your modified adjusted gross income must be less than $206,000, if married; less than $139,000, if single.

Can I get a 401(k) on my own?

No, you can only access a 401(k) with the help of an employer. Your employer must decide to offer a 401(k) plan to all of the employees (or within the eligibility criteria they set, which often include age or years of service).

What do others do? Top Q&A about how people use their 401(k) 

Figuring out how much to save, when to increase contributions, and more, can be confusing. One helpful thing is to know more about what other people are doing in their 401(k).

Can people use a 401(k) right away?

  • Roughly 70% of employers who offer a 401(k) plan allow employees to be eligible to start using it immediately. That means they can start setting aside money (and getting tax benefits) as soon as their first paycheck. Only 9% of employers require at least one year of service before being eligible to take part in a company 401(k) plan. Once you've reached eligibility, you can come back at any point to update your 401(k) or to start saving.

How much do people put in their 401(k) per year?

  • The average person in America with a 401(k) contributes 7% of their income to their 401(k) account per year. Among participants with a Human Interest 401(k), the average contribution rate is 10% of their earnings - they’re setting themselves up to be in a much stronger financial position for retirement. 

Do most people get an employer match?

  • Roughly six in ten employers who offer an employer match start giving it to employees as soon as they start participating. At roughly one in five companies, employees don’t become eligible for employer matching contributions until at least one year of service. (Source)

What's the typical employer match?

What's the typical vesting schedule for an employer match?

  • Roughly half of plans use immediate vesting of employer matching contributions, 35% transfer a portion of the employer contributions gradually over time (aka a graded vesting schedule,) and roughly 20% hold the matching contributions until the employee reaches a specific service mark (aka a cliff vesting schedule). Read more about vesting schedules below.

What's the average 401(k) balance?

  • The average 401(k) balance varies by age but overall is roughly $105,000. This may seem like a large amount of money, but remember that your retirement savings need to be big enough to support you throughout retirement, which can last 20 years or more. If we do the math based on the average balance, $105,000 stretched out over 20 years means you’ll have just $5,250 per year. 

An example: The power of a 401(k) 

The true power of a 401(k) comes when you look at the tax advantages it gives you relative to other retirement savings tools, and how this builds up over time. Regularly contributing - even a small amount of money - is key. Let’s say you earn $50,000 per year (meaning you’re in the 22% tax bracket) and you have $15,000 that you want to save for retirement. Let’s go through a few options you have before you: 

  • You could put that into a brokerage account. That means, you’d be taxed 22% off that $15,000, i.e., you’d pay $3,300. The remaining $11,700 would go into the brokerage account and grow, less any fees, not to mention that you’ll have to pay capital gains taxes annually.

  • You could put that into a traditional 401(k). By doing so, you'll reduce your taxable income by the amount of your contribution, and only pay taxes on the withdrawals when you reach retirement age and are presumably in a much lower tax bracket.

What else to know? Special circumstances and your 401(k) 

There are many times when you may have special circumstances regarding your 401(k). We’ll review some of those here: 

You change jobs

You have multiple 401(k)s

  • One of the results of changing jobs may be that you have more than one 401(k). Having more than one 401(k) is allowed, even concurrently contributing to more than one, as long as you don’t exceed the annual contribution limit. If you have one (or more) 401(k)s from a previous employer, it can be hard to track (read more here). As a result, many people prefer to consolidate by performing what’s called a “rollover,” where the funds from a 401(k) you had with a previous employer are moved into your 401(k) you have with your current employer. One thing to note: traditional 401(k) funds cannot be commingled with Roth 401(k) funds.

You need the money before retirement 

  • When is it OK to withdraw money from a 401(k)? Since a 401(k) is a retirement account, the rules make it hard for you to take money out before retirement age — age 59 ½. There are, however, a few exceptions, including: 

  • For significant financial hardship, such as:

    • To pay for certain medical expenses

    • To buy a home as a principal residence

    • To pay for up to 12 months’ worth of tuition and fees

    • To prevent being foreclosed on or evicted

    • To cover burial or funeral expenses

    • To pay for repairs or losses to a principal residence (such as from a fire, earthquake, or flood)

    • For the birth or adoption of a child -- you can take up to $5,000 thanks to legislation that passed at the end of 2019. (Read more on how the SECURE Act changed 401(k) withdrawals.)

    • For coronavirus-related hardship: a) you or your spouse or dependent were sick with coronavirus, b) you faced adverse financial consequences as a result of being quarantined, furloughed or laid off, or having work hours reduced due to coronavirus, c) you faced adverse financial consequences as a result of being unable to work due to lack of child care due to coronavirus, or d) you faced adverse financial consequences as a result of closing or reducing hours of a business that you own or operate.

    • Note: if you do take out money before age 59 ½, you’ll need to pay. You’ll be taxed on the full balance of your account AND you’ll have to pay an additional 10% early withdrawal penalty on top. 

You go through a divorce

  • A 401(k) typically comes up during divorce proceedings. Any funds that were contributed to a 401(k) during the marriage are considered to be joint property (barring prenuptial agreements that state otherwise). If you were married for 5 years and contributed $10,000 during that time to your 401(k), then half of that - $5,000 - is what your ex-spouse would be entitled to. In some cases, couples look for joint assets of equal value, resulting in one person keeping the 401(k) and one person keeping the equivalently-valued item. In many cases, however, couples going through a divorce split the 401(k), and this requires filing a Qualified Domestic Relations Order (QDRO, pronounced "qua-dro"). One thing to watch: with many 401(k) providers, a QDRO can come with a hefty transaction fee ($200-500 or more). At Human Interest, it’s $0. We never charge for a QDRO or more than twenty 401(k) transaction fees

If you die

  • Thinking about the what ifs can be uncomfortable but ensuring that you have 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 vs. having them rolled into the rest of your estate.  

    • If you’re married: Federal law says your spouse* is automatically the beneficiary of your 401(k). Even though this is the law, you should still fill out the beneficiary form with your spouse's name. If you want to name a beneficiary other than your spouse, you may need to complete additional paperwork.

What else do I need to know about a 401(k)? 

What is auto-enrollment?

  • Auto-enrollment (aka automatic enrollment) allows an employer to automatically sign you up to participate in, i.e., to make contributions to, the company’s 401(k) plan. Typically, the employer assigns a default percentage of income to be taken from your paycheck and deposited into your 401(k) account. You can contact your employer to opt out of the 401(k) plan. Contact the 401(k) provider to adjust the amount of money that goes from your paycheck into your 401(k) each pay period.

What is auto-escalation?

  • Auto-escalation refers to a default setting where the percentage of income taken from your paycheck and put into your 401(k) account increases every year. Often, the increase is 1% per year. You can contact your 401(k) provider to adjust the amount of money that goes from your paycheck into your 401(k) each pay period.

Limits for high-income earners:

  • As determined by the IRS, employees whose annual income ($135,000 in 2020 or 2022) or percentage ownership in the company (5%) meets a specific threshold may only contribute a portion of their earnings. If you own 5%+ of the business that’s offering the 401(k) plan or are a family member of someone who does, you may have a lower contribution limit.

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.

What is a vesting schedule?

  • A vesting schedule establishes the times at which employer contributions are transferred ("vested") to an employee over time. Even though the employer may make contributions during a specific pay period, many employers offer matching timelines do so in order to incentivize longer-term employment by offering partial ownership over time. 

There are three types of vesting schedules:

1. Immediate vesting:

  • Employees own 100% of the employer matching contributions immediately.

2. 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.

3. 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 vary by employer. You can look up the vesting schedule associated with your 401(k) in your plan documents (available in your online account or mailed to you). 

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.

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