How Does A 401K Plan Work?

Simple, concise, and useful information for consumers about how a 401K Plan actually works

A 401K Plan is a benefit offered by many employers to help employees save for retirement. Employer-sponsored pension plans are increasingly falling by the wayside and being replaced by this type of retirement plan. The 401K is named after the section of the IRS code that allows for the administration of the tax-deferred retirement savings plan by employers. There is commonly a waiting period before employees become eligible to participate in a company’s 401K plan. This article aims to help consumers understand how does a 401K plan work once they become eligible.

Contributions

An employee is asked to contribute a percentage of their before-tax earnings to the plan. This is typically done through payroll deduction. Many employees won’t even miss the deducted earnings because they are taken out of gross earnings. No income tax is paid on these contributions until a withdrawal occurs. Some companies match a percentage or dollar-for-dollar the amount that the employee contributes. This matched money is sometimes subject to a vesting schedule. This means that a person must work for the company for a specified period of time before they can collect the matched portion of the plan.

Growing Your Money

How does a 401K plan work to build a savings for retirement? The contributions are invested in numerous ways. The employee typically chooses mutual funds that may include high-risk, moderate-risk, or low-risk investment options for their savings. This may include stocks, bonds, annuities, or money market investments. The employee can distribute the contributions in one or in several of these investment options. The money that is earned through these investments accrues in the 401K retirement plan along with the contributions.

Withdrawal of Funds

There are restrictions on when the money from a 401K plan can be withdrawn. Termination of employment, disability, retirement and death are common reasons for distributions from a plan. Some participates may also opt to withdrawal fund upon reaching the age of 59 ½ (or 55 in some cases). Withdrawing money from a 401K savings before retirement may result in a 10% early withdrawal penalty from the IRS. Some plans offer employees the option of taking loans against a portion of their 401K savings.

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1. What Is A 401K Retirement Plan?
2. What Is a 401k Retirement Plan?
3. What Are The Features Of A 401k Plan?
4. What Is The Purpose Of A 401K Plan?
5. What Is An Individual 401K?

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