Before you want to know “How Does 401(k) Works?”, you should know What 401(k) was. A 401(k) is a tax-advantaged retirement savings plan. It gets its name from a part of the U.S. tax law. This plan is provided by employers and is a type of defined-contribution plan. Employers might match the money employees put in, and in some cases, this matching is required.
There are two main kinds of 401(k) plans: traditional and Roth. In a traditional 401(k), the money you put in is before taxes (Pretax), which lowers your taxable income, but you will pay taxes when you take it out in retirement. In a Roth 401(k), you contribute money that has already been taxed. You don’t get a tax break when you contribute, but when you withdraw money later, it is tax-free if you meet certain conditions.
Here, we explain how to begin a 401(k), how these plans function, and tips for maximizing their benefits.
Peter Lazaroff, a financial advisor and chief investment officer at Plancorp, said the key to making decisions about your 401(k) is to actually use it. Ideally, you should contribute the maximum amount, but at the very least, you should put in enough to get your company’s matching contribution.
In 2023, Americans put away an average of 7.1% of their pay in 401(k) plans, which was more than the total personal savings rate for that year. Fewer than 12% of working-age Americans were set to fully contribute to their plans in 2023. For 2024, the contribution limit for 401(k) plans is $30,500 for individuals aged 50 and older, including “catch-up” contributions, and $23,000 for those under 50.
How Does 401(k) Works?
Traditional 401(k) plans started in the early 1980s, letting employees contribute part of their salary before taxes, up to specific limits.
When an employee enrolls in a 401(k), they choose to put a portion of their paycheck straight into an investment account. Many employers will match some or all of that amount.
Workers must select the specific investments for their 401(k) accounts from options provided by their employer. These options usually consist of stock and bond mutual funds, as well as target-date funds that aim to lower the risk of losses as the worker nears retirement.
Contribution Limits
Traditional and Roth 401(k) plans are types of retirement accounts where both employees and employers can add money. The total contributions must stay within the limits set by the IRS.
The highest amount that either an employee or employer can put into a 401(k) plan is changed from time to time to keep up with inflation, which looks at increasing prices.
In 2024, employees under 50 can contribute up to $23,000 to their 401(k). Those who are 50 or older can add an extra $7,500 as a catch-up contribution.
Conclusion
A 401(k) plan is a retirement savings plan offered by employers. It lets you contribute a certain amount of money each year and invest it for your future after you stop working.
There are two main kinds of 401(k) plans: traditional and Roth. A traditional 401(k) lets you put in money before taxes, which lowers your taxable income and gives you a tax benefit at the time of contribution. However, you will owe regular income tax when you take money out. On the other hand, a Roth 401(k) requires you to contribute after taxes, so you don’t get a tax break upfront, but your withdrawals in retirement are tax-free. Both types of accounts can receive contributions from your employer, helping to boost your savings.