401(k)s are the most popular retirement savings plan. More than 60 million Americans—or about 38% of the working population—use one to invest money they'll live off in retirement.1
But just because they're common doesn't mean they're well understood. Whether you're a veteran retirement saver or are just getting started, here's what you need to know about 401(k)s and how they work.
What is a 401(k)?
Named for the tax code section that created it, a 401(k) is an employer-sponsored retirement savings plan with special tax benefits. (The exact tax advantages depend on which kind of 401(k) contributions you make—more on that later.) Employers typically offer 401(k)s as part of a benefits package to attract and retain workers.
Not everyone has access to a 401(k). Depending on your industry, you may be able to contribute to a similar retirement plan, like a 403(b) or 457(b), instead of a 401(k). Self-employed people can open a type of 401(k) on their own called a self-employed 401(k), and anyone who earns an income (or who is married to someone who does) can save for retirement—in addition to a 401(k) or in place of one—within an individual retirement account (IRA).
How does a 401(k) work?
401(k)s let you contribute part of each paycheck into a retirement account, where you can invest in assets such as mutual funds or exchange traded funds (ETFs), for example.
The ability to invest for retirement is a major incentive to use a 401(k)—investing your money gives it a chance to benefit from compounding returns and a potential to grow over time. But 401(k)s also offer tax advantages. Unlike contributions to regular brokerage accounts, contributions to a traditional 401(k) are not taxed until you begin withdrawals in retirement. Distributions prior to retirement may be subject to a 10% penalty as well as ordinary income.
Some employers offer a second type of 401(k) called a Roth 401(k), where you invest after-tax money today and don't pay income taxes on your withdrawals in retirement. Not sure which to pick? See whether contributing to a Roth or traditional 401(k)—or even both—makes sense for you.
401(k)s can be a helpful tool to fund a secure retirement. A few key benefits include:
The science is clear: We are more likely to save when we don't have to think about it.2 That's where 401(k)s shine. By automatically funneling money from your paycheck to your retirement savings, there's no opportunity to spend the money on anything else.
A key advantage of 401(k)s is that your employer may also contribute to help you save for retirement. This typically comes in the form of a 401(k) match, a.k.a. when your company agrees to contribute a certain amount based on what you contribute. This may come in the form of a full, dollar-for-dollar match up to a certain percentage of your salary or a partial match, where your employer matches a fraction of what you do, such as 50%, up to a percentage of your salary.
Fidelity recommends aiming to contribute at least enough to get the full match amount.
Compounding is when your investment returns earn returns of their own. Because it puts your money to work for you, compounding returns could be a powerful way to grow wealth over many years or even decades.
The potential snowball effect of compounding makes early saving or investing, particularly in tax-advantaged retirement accounts like a 401(k), that much more enticing since the earlier you start investing, the more compounded returns you can hope to make.
401(k) contribution limits
The annual employee 401(k) contribution limit is $20,500 in 2022 for those under age 50. If you contribute to both a traditional 401(k) and a Roth 401(k), the contribution limit for both accounts is still $20,500 in 2022. Two different kinds of 401(k)s does not equal double the contribution limit. Those age 50 and older can contribute an additional $6,500 as a catch-up contribution.
Most 401(k) plans have formulas built in to keep you from running over your annual maximum, but if you do exceed the annual 401(k) contribution limit, you have until you file your taxes to withdraw the excess contributions and fix the mistake. If you don't, you could be taxed twice, once on the excess contributions in the current year and a second time upon withdrawals, plus a potential additional 10% early withdrawal penalty.
401(k) withdrawal rules
The federal government imposes some restrictions about when you can withdraw money from your 401(k). Generally, you must wait until you're at least age 59½ to access the money without paying a penalty. Before then, you may owe a 10% penalty on top of income tax in all but a few circumstances. Those special exceptions include financial hardship from medical costs and foreclosure.
One way to avoid paying the penalty and income taxes is by taking a loan from your 401(k), which some, but not all, plans allow. Keep in mind, however, that any money you take out of your 401(k)—even for a short time—misses out on the opportunity to compound and grow. And if your employment situation changes, you might have to repay your loan in full in a very short time frame. If you can't repay the loan for any reason, the remaining loan balance is considered a withdrawal and you may owe both taxes and a 10% penalty if you're under 59½.
Required minimum distributions (RMD)
According to the IRS, you must withdraw a certain amount of money each year starting at age 73—called required minimum distributions (RMDs)—from traditional IRAs and workplace retirement plans, including 401(k)s. RMDs are equal to a percentage of your total eligible retirement account holdings as of December 31st the prior year and based on your life expectancy.
The exact amount can be tricky to calculate, so consider reaching out to a financial or tax professional for help, or try Fidelity's online calculator. It's important to start withdrawing RMDs when required. Otherwise, you may end up owing a penalty equal to 50% of the amount not withdrawn—and that's in addition to taxes you may owe when you eventually take the withdrawal.
What happens to a 401(k) when I switch jobs?
You don't have to break up with your retirement plan when you and your employer part ways. You have several options for what to do with old 401(k)s: keeping your money where it is, moving it to a rollover IRA, transferring it to your new 401(k), or taking a withdrawal. Each has its pros and cons, which we cover in our guide to 401(k) rollovers.