What Does 401(k) Mean?

Many Americans save for retirement through an employer-sponsored 401(k). After all, the 401(k) is the most common retirement vehicle utilized these days. 401(k)s are relatively simple to join and even easier to contribute. This automated, hands-off system is excellent for maximizing participation, thus increasing the number of people saving for retirement. However, most 401(k) participants don’t fully understand how 401(k)s work or even what 401(k) means. Understanding the basics about 401(k)s can go a long way in maximizing your 401(k)’s potential in building wealth for retirement.

The term 401(k) represents the specific U.S. Internal Revenue Code that defines “Cash or Deferred Arrangements.” Specifically, Section 401, Paragraph K outlines the rules and guidelines surrounding employer profit sharing and stock plans, and most notably Employee Retirement Income Security Act (ERISA) plans. ERISA plans encompass employer-sponsored retirement plans such as 401(k)s. Within Section 401(k) of the Internal Revenue Code are guidelines surrounding withdrawals, contribution limits, eligibility requirements, among many others.

What does 401(k) stand for?

In 1978, Congress passed the Revenue Act, which included provisions that were added to the Internal Revenue Code—Section 401(k)—that allowed employees to avoid being taxed on deferred compensation.

This deferred compensation is what employees contribute to their 401(k)s for retirement. The IRS allows these contributions to be tax-deferred, meaning taxes aren’t due at the time the income is earned. Instead, taxes are due when distributions are taken out of the 401(k) during retirement. 

401(k)s were created as a retirement vehicle in 1980 when benefits consultant Ted Benna referred to Section 401(k) while researching tax-friendly ways to build retirement programs for his clients. He created the idea for employees to save pre-tax money into a retirement plan, with the ability to receive an employer match. His clients didn’t like the idea. However, Benna’s company, The Johnson Companies, began providing a 401(k) plan to its employees, becoming the first employer to do so.

In 1981, the IRS issued new rules that allowed employees to fund their 401(k) through payroll deductions, which kickstarted the 401(k)’s popularity.

How do 401(k)s work?

401(k)s are an employer-sponsored retirement plan. Provided by employers through their benefits package, many companies include signing up for their retirement plan as part of their onboarding process for new employees. However, employees can join 401(k)s even after they have been with the company for a considerable time.

Sign Up

As mentioned, many employers will have their newly hired employers join their 401(k) plan on the employee’s first day. All that’s needed is personal information to open the account, to elect a certain percentage of income to be automatically contributed from paychecks, and what funds to invest into.

Many companies require employees to fulfill a preliminary period before being eligible for their benefits package, including their 401(k). These periods can last anywhere from 30 to 90 days, even as long as a year. Once eligible, employees will be prompted to join the company’s 401(k) plan.

Contributions

Contributions are the money you put into your 401(k) through your automatic payroll deductions. When you join your employer’s 401(k) plan, you will elect a certain percentage of your income to save. One of the best features of 401(k)s is that these contributions are automatically made for you. When you receive your paychecks, the money is already taken out and put into your 401(k). This allows for much more participation and consistency over having employees manually contribute to their 401(k)s after they’ve been paid.

The IRS limits annual contributions to a 401(k) to $19,500 with an additional $6,500 for those over 50. Total contributions to a 401(k), including employer matching contribution, are limited to $58,000 annually.

Taxes

Perhaps the most prominent feature of 401(k)s and why they were created in the first place is their tax-deferred status.

When you receive your paycheck and see your 401(k) contributions, that amount is calculated before taxes are taken out. This reduces your tax obligation for the tax year. Your money then grows tax-deferred each year, allowing it to grow more and more over the years.

Distributions during retirement are then taxed at the applicable tax bracket you’re in at that time.

Employer match

One of the benefits of joining an employer-sponsored retirement plan is the ability to receiving employer matching contributions. If an employer elects to match its employees’ 401(k) contributions, this could add thousands of dollars to employees’ 401(k)s year-over-year.

The typical employer match is 3% of its employee’s salaries. For example, if you make $100,000 per year and contribute 5% ($5,000) towards your 401(k), your employer would contribute $3,000 (3%).

Employer matching contributions are tied to vesting schedules. Vesting means you are entitled to the money your employer has contributed to your 401(k). If you were to quit or get fired without being vested, you could forfeit the employer’s matching portion of your 401(k) balance. Many employers enforce a vesting schedule for their match. A vesting schedule is a period of time employees must stay with the company in order to keep the match if they leave.

Penalties

Because 401(k)s are tied directly to the Internal Revenue Code, 401(k) participants must abide by the rules and guidelines set within the tax code. One of the defining rules—and potentially most costly—is regarding early retirement withdrawals. 

401(k)s are designed to provide American workers a way to save for retirement. This helps ease the burden on the social security system from being the sole retirement fund source. As a result, the IRS imposes penalties on early retirement withdrawals that can drain a 401(k) and put the retiree’s retirement income in jeopardy.

The IRS charges a 10% penalty tax for any withdrawal made from a 401(k) before the account holder turns 59½. This 10% penalty is assessed on the total amount taken out of the 401(k) during that tax year.

Last thoughts.

Now that you know a little about how 401(k)s were created and how they work, you can utilize your 401(k) to help you build wealth for retirement. However, it’s essential to understand your employer’s 401(k) plan, as each may be different. Your employer’s 401(k) plan should come with a summary plan description that outlines more specifics of their plan like employer matching, withdrawal options, vesting schedules, and investing options. When in doubt, talk to your human resources department or plan administrator as they will have the most accurate information regarding your specific retirement plan.