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The Exclusive Guide: How Does a 401K Work?

What is a 401K? 

A 401K is a retirement plan that most employers offer employees to help them save for retirement. 

It is also called a personal pension saving account by the IRS. Employers often offer this retirement account for full-time employees. Still, it can be offered to part-time employees at the employer’s discretion. 

How Does It Work? 

When you sign up for a 401K through your employer, you essentially enter into an agreement where you automatically put up a percentage of your money every paycheck and put it towards retirement. 

That money will get put into your 401K (personal pension savings account). It will accumulate over time as you keep adding money to the account. 

Now 401 K’s are not just ordinary savings accounts. There are several benefits to opening up a 401K besides just saving for retirement. We will list those benefits below. 

What are some benefits of opening a 401K? 

One of the biggest benefits of opening a 401K as your retirement account is the company matching programs.

Your company puts extra money into your 401K plan. This employer contribution is applied every time you get paid and contributes some of your money into the account. 

How much your company contributes to your retirement account varies. 

An example of this could be you put $200 into your 401K account, and your job contributes an extra $100

It’s free money for just saving for retirement. 

What Are The Tax Benefits? 

As you know, the government wants its citizens to save money for retirement. 

So, to encourage Americans to save more for retirement, they made your 401K contributions tax deductible.

Yes, contributing to your 401K lowers your taxable income. Which means you ultimately pay less in taxes. 

The second perk, you also get compounding tax-free growth on your investments. 

That money you have in your 401K account will be invested. 

When you create your 401K plan, you can determine how much risk you want to take with your investments. 

However, this investment choice could limit your options, especially if you choose to go the safer route and invest in less risky companies. 

As your investments grow within your 401K account, you will not pay any taxes on that growth. 

You won’t pay taxes until you start taking money out of the 401K. 

So your money will continue growing faster because it will continue to compound each year without any money being taken out due to taxes. 

What are the disadvantages? 

Tax Disadvantages

As mentioned before, one of the disadvantages of putting money into a 401K is having to pay taxes when withdrawing the money. 

You aren’t able to lock in a low tax rate. So how much you end up paying in taxes will depend on the tax rate of when you withdraw the funds. 

The tax rate could be lower than it is now or much higher regarding retirement.

When you withdraw the funds from your 401K account, you will pay taxes on the principal and the growth. 

However, you will not be paying capital gains tax for your withdrawal. But instead, you will be taxed at your ordinary income rate. 

Contribution Limit 

There is a limit on how much money you can contribute to your 401K each year. 

The amount you can contribute varies each year and is based on the percentage of inflation for that year. 

For example, the contribution limit for this year (2022) is $20,500. It used to be $19,500 in 2020 and $19,000 in 2019, but inflation is much higher this year than before. 

Note: If you’re 50 or older, you can contribute an additional $6,500 for a total of $27,000. 

Early withdrawal penalty 

If you take out your money before 59½, you will get hit with a 10% penalty. 

So you will still have to pay taxes on the withdrawal, but you will also get hit by a 10% fee. 

Note: There are some exceptions to this rule. Suppose you have a disability, have unreimbursed medical bills, owe the IRS, etc. In that case, you might be able to take out money with no penalty. 

To be on the safe side, always make sure to read your 401(k) fee disclosure statement.

Retirement Account Fees 

This retirement account does have annual fees. This fee can typically range from 0.88% to 0.41%. 

You pay these fees annually to financial firms. Depending on the size of your employer’s company, you could end up with a retirement plan with a very high or low fee. 

The fees are automatically withdrawn from your account as a percentage of your savings.

A study by Morningstar showed that, on average, employees who work for smaller companies end up paying higher fees than those at bigger companies. 

“Workers at employers with smaller plans who are saving just as much as those at employers with larger plans could have around 10% less in assets at retirement because of higher fees” – Szapiro from Morningstar. 

As a result of these fees, someone working at a smaller company would have to work a lot longer to have the same savings as someone working at a more prominent company with smaller fees. 

What Happens When I Leave My Job? 

When you leave your company, you will have options on what to do with your 401K plan.

That 401K plan can be left with your company and will always be yours. Even if you never work for the company again. Your previous employer cannot touch your 401K plan even if you are no longer their employee. 

However, suppose you don’t want to leave your 401K plan with your previous employers. In that case, you can always choose to roll it over into another retirement account. This rollover is tax-free, so it will cost you nothing in taxes to do the translation. 

The final option is to cash out your 401K funds. Remember, if you withdraw before 59½, you will have to pay taxes and a 10% penalty

To Summarize  

To summarize, the 401K is a retirement account offered by employers to help their workers save for retirement. This plan comes with company contributions and tax benefits.

This is an excellent tool for saving for retirement. However, suppose you do plan to open a 401K. In that case, it is recommended that you do so as early as possible to take advantage of its compounding effects and tax benefits. 


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