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Published: Apr 13, 2022 14 min read
Seed Packet Labeled 401k Next To A Small Flower Pot And Shovel
Jose Velez / Money

One of the most common ways of saving for retirement is by contributing to a 401(k), an employer-sponsored retirement savings account.

So, what is a 401(k) and how does it work? Read on to learn more about 401(k) plans and ways to contribute to and manage your account.

How does a 401(k) work?

The 401(k) name comes from a section of the U.S. Internal Revenue code that outlines the rules for this type of account — section 401k subsection K.

When you sign up for a company 401(k)plan, you agree to have a percentage of your salary automatically deducted from each paycheck to fund the account. You decide how much to contribute, and your employers may match part or all of that contribution.

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Types of 401(k)

There are two types of 401(k) plans: traditional and Roth 401(k), which differ in tax treatment.

Traditional 401(k)

In a traditional 401(k) plan, elective deferrals are made from your paycheck before taxes and deposited into an investment account in mutual funds that could include money market investments, bonds and stocks.

Since deductions to your paycheck are made pre-tax:

  • Your taxable income is reduced, and, therefore, you'll have to pay fewer taxes.
  • There’s a tax fee of around 10% for early withdrawals before age 59 ½ , with a few economic hardship exceptions such as evictions and funeral expenses.
  • You’ll still have to pay income taxes on your withdrawals.

A traditional 401(k) has income limit subject to the cost of living adjustments (COLA). For 2022, the income limit is $305,000. In 2021, the limit was $290,000. Employer matching contributions apply only up to the limit.

Roth 401(k)

With a Roth 401(k), elective deferrals are made from your paycheck after taxes. Contributions to your Roth 401(k) are taxed in the contribution year. And at the time of retirement (and withdrawals), your contributions and investment earnings are tax-free.

Unlike a traditional 401(k) and a Roth IRA, the Roth 401(k) doesn’t have an income limit.

If you’re interested in a Roth IRA as part of your financial plan, check our selections for the best roth IRA accounts.

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Contributing to your 401(k)

401(k) accounts, both traditional and Roth 401(k), have yearly contribution limits. Fortunately, those limits don’t include your employer’s contribution.

What is the maximum 401(k) contribution for 2022?

401(k) contribution limits change yearly depending on inflation. For 2022, the IRS, raised the contribution limit to $20,500 from $19,500 in 2021.

Many 401(k) plans include the option for those age 50 and over to make catch-up contributions . The limit for this additional annual contribution for 2022 is $6,500, for a total contribution of $27,000 per year.

How much should you contribute to your 401(k)?

The recommended employee contribution should be at least the same percentage as the employer's maximum contribution. If your employer offers a 3% match, you should contribute at least that amount to get the free money of the match.

While that’s the minimum, many financial advisors recommend you aim to contribute at least 10% of your pay (or 15%, including the company match) in order to have enough money saved for retirement.

If you max your 401(k) contribution and want to continue saving for your retirement, consider opening an individual retirement account (IRA). The downside to having both an IRA and a traditional 401(k) is that your IRA contributions may not be fully tax-deductible if your salary exceeds certain thresholds.

What happens to your 401(k) when you quit or switch Jobs?

If you recently quit or switch jobs, you have several options regarding what to do with your 401(k) account.

If you switch jobs

When you switch to a new job, you have three options for your 401(k) account:

  • Transfer your account to your new employer’s plan, if the new plan accepts such transfers
  • Leave the account where it is
  • Convert your 401(k) into a rollover IRA

Transferring your 401(k) account

If your new plan accepts transfers, you can rollover your 401(k) to the new employer’s plan manager without any fees. This move is recommended for those with more than $5,000 in their current 401(k) account. If your total is below $1,000, your former employer may close your account and give you the money in the form of a check.

Keeping the account with your past employer

If you decide to keep the account with the financial institution tied to your employer’s plan, be aware that you cannot make more contributions. Your new employer may require you to wait before activating your new 401(k) benefits.

Convert your 401(k) into a rollover IRA

If your new employer doesn’t provide the benefit of a 401(k) account, consider rolling your 401(k) into an IRA.

With a rollover IRA, you don’t need to pay withdrawal fees to transfer, and you get to maintain the tax-deferred status of your account. However, you can’t contribute to an inactive 401(k) account.

If you quit your job

Your 401(k) is tied to your employer. If you leave a job, this means you won’t be able to contribute to the account anymore. However, there are ways to manage your 401(k) plan after you quit.

  • If your account total is less than $1,000, your employer may close it and mail you a check for the total amount left. But remember, you can also deposit that money into a rollover IRA if you don’t want to pay fees to the IRS.
  • Suppose you still have between $1,000 to $5,000 when you quit your job. In that case, your employer can put your 401(k) money into an individual retirement account (IRA)
  • If there’s $5,000 or more in your account, we recommend you transfer your money into a rollover IRA to avoid early withdrawal fees. You can open this account in the financial institution best suited for you.
  • If your employer allows it, you can also leave the money in the account without making any more contributions to it.

Keep in mind that depending on your plan manager and employer, the vesting in your account might vary.

Vesting in a 401(k) is the ownership of the matching funds added by your employer to the retirement account. If you don’t plan to quit your job soon, don’t worry. The IRS establishes that the employers’ vesting has to be 100% at the time of retirement or if the plan is terminated.

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What happens to your 401(k) when you die?

When building your personal financial plan, it’s almost impossible to ignore the inevitability of illness and death. If you are married or have financial dependents, it’s important to understand what happens to your 401(k) when you die.

Suppose the account owner is married at the time of death, and the spouse is named a beneficiary on the account. In that case, the surviving spouse can

  • Keep and manage the account, meaning they can make or defer withdrawals
  • Rollover their deceased spouse 401(k) into their own 401(k) account
  • Withdraw the money and use it as they please.

Surviving spouses are not subject to the traditional early withdrawal penalty if they withdraw money before age 59 ½. If the deceased spouse dies after turning 72, the surviving spouse must make required minimum distributions (RMDs) from their newly inherited 401(k) account.

If the account owner leaves someone other than their spouse as the beneficiary, the beneficiary has two options:

  • Keep the account. To keep it, they must start taking RMDs by December 31st of the following year after the original owner’s death
  • Close the account and take the money within 5 years of the account owner’s death.

This money has to be reported in tax returns. For beneficiaries, RMDs are calculated based on their life expectancy.

When can you withdraw from your 401(k)?

Building a 401(k) can be a long process. What will happen to you later in life if you start spending your hard-earned savings now? The best way to avoid early withdrawals is to think about your 401(k) as the primary fund to support you throughout your elder years.

The age to start withdrawing from a 401(k) without penalties is 59 ½. Required minimum distributions are mandatory after turning 72 years old unless still employed, an important number for those interested in keeping and growing their 401(k) for as long as possible.

One of the benefits of waiting until retirement to start making withdrawals is that your income tends to decrease as a retiree, leaving you in a lower tax bracket than when you were employed. This means you'll pay lower taxes on your 401(k) when you retire than if you made those withdrawals while still employed.

401(k) early withdrawal penalties

Penalties are charged to those who withdraw early from their 401(k). These penalties were established to persuade people to save their money until retirement.

An early withdrawal penalty of 10% is applied to those making withdrawals before turning 59 ½. That tax penalty is in addition to the regular income tax owed at the time of withdrawals.

You can avoid this penalty if you retire or lose your job when you’re 55 years old. Remember, this only applies to your current 401(k), not to a 401(k) still tied to a past employer.

To calculate the cost of an early withdrawal, you need to consider: withdrawal amount, annual salary, age, early withdrawal reason, planned retirement age, annual rate of investment return, and the current federal income tax rate.

Here is a scenario for someone who is single (not married filling jointly), who lives in California and has a salary of $78,000:

  • Federal income tax at 22% on the $20,000 401(k) distribution = $4,400
  • Federal income tax penalty at 10% on the $20,000 401(K) distribution = $2,000
  • CA income tax at 8% (it could be partially/fully at 9.3%) on the $20,000 401(k) distribution = $1,600
  • Total taxes = $8,000
  • After tax net cash inflow = $12,000

Early withdrawal penalties are avoidable when the early withdrawal is justified by an emergency situation. You can avoid this penalty if you use your 401(k) money

  • For a down payment on your primary residence
  • To avoid eviction
  • For primary residence repairs
  • To cover medical expenses made by the account owner, spouse, dependents, or beneficiaries
  • For funeral expenses
  • To cover college tuition or room and board for the account owner, spouse, dependents, or beneficiaries

When you must withdraw from your 401(k)

A 401(k) is meant to support you in your retirement. It wasn’t created to be kept forever.

When the account owner hits 72 years of age, or 70 ½ if the age was reached before January 20, 2020, you must take required minimum distributions (RMDs) unless you’re still employed. Another exception is for those owning more than 5% of the company they work for.

RMDs are required 401(k) withdrawals that must be made every year after reaching the established age. These required withdrawals are calculated using the life expectancy of the account owner.

Remember, RMDs are treated as ordinary income, therefore, are taxable.

IRA vs 401(k)

An IRA and a 401(k) are main retirement accounts offering tax benefits to their owners. We recommend finding a financial advisor to guide you in your financial and retirement goals.

IRA 401(k)
Not tied to an employer Tied to your employer
Doesn’t offer employer match If available, it includes employer match
Contribution limits for 2022 are: $6,000 (for those under 50 years old), or $7,000 (for those over 50 years old and over) Contribution limits for 2022 are $20,500 (for those under 50 years old) or 27,000 (for those 50 years or older)
Variety of investment options Investment options limited to what the plan offers
Contributions are allowed after retirement Cannot make any contributions if retired or unemployed

401(k) pros and cons

Pros
  • High contribution limits
  • Contribution helps decrease taxable income [for a traditional 401(k)]
  • Payroll deductions
  • Contributions allowed after turning 72 years old if still working
  • Available for self-employed business owners
Cons
  • Limited investment options
  • Account holders may have to cover 401(k) fees
  • Can only contribute if employed
401(k) FAQ
What is a 401(k) and how does it work?
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A 401(k) is an employer-sponsored retirement plan that allows employees to have contributions taken out of their paychecks and deposited into an investment account.

Contributions to a traditional 401(k) are tax-deductible, and many employers fully or partially match their employer's contributions.

How much should I have in my 401(k)?
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There is no magic number for the right amount of money you should have in your 401(k). It all depends on your retirement goals and lifestyle. For 2022, you can contribute up to $20,500 and, if you're 50 and over, additional contributions are allowed up to $6,500 per year.
How much should I contribute to my 401(k)?
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Your 401(k) contribution should be based on your financial and retirement goals. It's recommended that you contribute the amount of your employer match to avoid losing money. If you're able to contribute more, aim to save around 10% of your salary.
When can I withdraw from my 401(k)?
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No-penalty withdrawals are allowed after turning 59 ½ years. If you withdraw from your 401(k) before turning that age, a penalty of 10% will be added. Hardship withdrawals are allowed without penalties to cover expenses in life-changing situations such as the down payment for a primary home, Covid-19 related illness, eviction, or college tuition.