What Is a 401(k) Plan?
A 401(k) plan is a retirement savings plan offered by many American employers that has tax advantages for the saver. It is named after a section of the U.S.
The employee who signs up for a 401(k) agrees to have a percentage of each paycheck paid directly into an investment account. The employer may match part or all of that contribution. The employee gets to choose among a number of investment options, usually mutual funds.
KEY TAKEAWAYS
- A 401(k) plan is a company-sponsored retirement account to which employees can contribute income, while employers may match contributions.
- There are two basic types of 401(k)s—traditional and Roth—which differ primarily in how they’re taxed.
- With a traditional 401(k), employee contributions are pre-tax, meaning they reduce taxable income, but withdrawals are taxed.
- Employee contributions to Roth 401(k)s are made with after-tax income: There’s no tax deduction in the contribution year, but withdrawals are tax-free.
- Under the CARES Act, the withdrawal rules were relaxed for those affected by the COVID-19 pandemic and required minimum distributions were suspended for 2020.
How 401(k) Plans Work
The 401(k) plan was designed by the United States Congress to encourage Americans to save for retirement. Among the benefits they offer is tax savings.
There are two main options, each with distinct tax advantages.
Traditional 401(k)
With a traditional 401(k), employee contributions are deducted from gross income, meaning the money comes from the employee’s payroll before income taxes have been deducted. As a result, the employee’s taxable income is reduced by the total amount of contributions for the year and can be reported as a tax deduction for that tax year. No taxes are due on the money contributed or the investment earnings until the employee withdraws the money, usually in retirement.
Roth 401(k)
With a Roth 401(k), contributions are deducted from the employee’s after-tax income, meaning contributions come from the employee’s pay after income taxes have been deducted. As a result, there is no tax deduction in the year of the contribution. When the money is withdrawn during retirement, no additional taxes are due on the employee’s contribution or the investment earnings.
However, not all employers offer the option of a Roth account. If the Roth is offered, the employee can pick one or the other or a mix of both, up to annual limits on their tax-deductible contributions.