What Is a 401(k) Retirement Savings Plan?
A 401(k) is a retirement plan sponsored by an employer that offers employees tax incentives to save money for retirement from their paychecks.
If you go to work for a large private employer, chances are you will be offered a 401(k) account. This tax-friendly retirement plan allows you to save and invest for retirement through payroll deductions. Since its inception 40 years ago, the 401(k) has become the retirement plan of choice for many employers, which have moved away from providing traditional pension plans. In 2017, assets in 401(k)s totaled $5.3 trillion.
How does a 401(k) plan work?
Contributions to a traditional 401(k) are deducted from your paychecks before the money is taxed. You determine the pretax amount you invest each pay period, although the maximum 401(k) contribution you can make in 2018 is $18,500 if you’re younger than 50. If you’re age 50 or older, you can get an added savings boost by making up to a $6,000 catch-up contribution, which brings the annual maximum 401(k) contribution to $24,500. In 2019, the maximum annual 401(k) contribution increases by $500 to $19,000; the limit on catch-up contributions remains at $6,000. The money you save in a 401(k) account grows tax-deferred until you withdraw it in retirement. At that point, you will owe ordinary income tax on the withdrawals. If you take out money before age 59½, you generally will be hit with a 10% early-withdrawal penalty on top of taxes.
Employers typically provide a mix of mutual funds for you to invest in, including low-cost index funds that track the broad stock market and bond market. Other 401(k) investment options might include company stock, exchange-traded funds (ETFs) and variable annuities.
The most popular investment options in 401(k)s are target-date funds, which held $1 trillion in assets as of last year. With target-date funds, you choose a fund whose name contains the date closest to your expected year of retirement. The fund manager will invest aggressively when you’re younger, and the fund will gradually become more conservative as you near retirement age.
Auto-enrollment in 401(k)s
Even if you don’t actively enroll in a 401(k), your employer might automatically do it for you. According to a 2018 survey by Willis Towers Watson, 73% of employers polled automatically enroll new employees in a 401(k), up from 52% in 2009.
With auto-enrollment, employers deduct, say, 3% or 4% from your pay and invest it in a 401(k) – often in a target-date fund based on your age. Some employers also automatically increase your annual contributions gradually, often stopping once you are putting aside 8% to 10% of your pay. You can always opt out.
Plans that use both auto-enrollment and auto-escalation of contributions have higher savings rates than those that don’t. According to a December 2017 survey by the Defined Contribution Institutional Investment Association, 70% of plans using auto-enrollment and auto-escalation features had savings rates of 10% or more among employees. Only 44% percent of plans that don’t have those features reached that level of savings.
Extra benefits of a 401(k)
In addition to building a nest egg for retirement, stashing money in a 401(k) lowers your current tax bill. That’s because your pretax contributions reduce the amount of current wages subject to tax. For example, if your monthly income is $4,500 and you contribute $1,000 of that to your 401(k), only $3,500 of your paycheck will be subject to tax.
Note that some employers offer employees the option to open a Roth 401(k) account instead of a traditional 401(k). As with a Roth IRA, contributions to a Roth 401(k) are made with after-tax dollars. The big benefit to workers is that withdrawals made in retirement aren’t subject to tax. Contribution limits to a Roth 401(k) are the same as a traditional 401(k).
Another benefit of a 401(k) is that many employers encourage participation in the plan by matching workers’ contributions by, say, 50 cents for every dollar an employee contributes -- up to 6% of pay. Some employers even contribute to workers’ 401(k)s regardless of whether employees put in their own money. On average, companies contribute 4.8% of an employee’s pay to the employee’s 401(k) account, according to the Plan Sponsor Council of America.
Make sure you contribute enough to receive your full employer match. Otherwise, you are leaving free money on the table. And if you’re not already maxing out your contributions, don’t forget to ramp up your savings with each pay raise until you reach the max.
Stay on top of 401(k) fees
Not all 401(k)s are created equal, and high fees can quickly eat away at an account balance. Pay close attention to the expense ratios of your investments and the administration fees charged by your plan. Check your statements or log in to your 401(k) account to research expenses ratios and fees.
According to a recent study from brokerage firm TD Ameritrade, 37% of participants thought their 401(k) plan didn’t charge any fees, and 22% weren’t sure how much the fees were. The average fee for a large-company plan is 1% of assets, according a study from BrightScope, which rates 401(k)s. Anything more and you’re paying too much, BrightScope says.
For help calculating the fees you pay, try TD Ameritrade’s free 401(k) Fee Analyzer. You’ll need to type in your fund information or provide your 401(k) account login credentials to allow read-only access to your account. And check the BrightScope website to see how your plan ranks against its peers on fees and other factors. If your 401(k) plan fares poorly, let your company’s benefits department know.