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What is a 401(k)? What to know about this retirement investment vehicle

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When it comes to contributing to a 401(k), it’s important to do your research first. / Credit: / Getty Images

If you work for a private company, one of the easiest ways to save for retirement is a company-sponsored 401(k) plan.

A traditional 401(k) ⁠- named after a subsection of the U.S. tax code ⁠- is a retirement plan offered by many employers. Employees choose to have a pre-tax percentage of their income withdrawn and put into the account. Employers typically offer a selection of stocks, bonds, cash, mutual funds and other investments.

Here’s what you need to know about the retirement savings account.

Find your retirement savings plan at Personal Capital How much of my income should I put into my 401(k)?

Most financial experts recommend you contribute 10% to 15% of your income, including employer contributions, called “matching” funds, to your 401(k). Many banks or financial websites offer easy-to-use retirement calculators, as does the Department of Labor.

Many employers offer what’s called a matching contribution as an employee benefit, but percentages vary. Say your employer offers 401(k) contributions at a 50% “match.” That means if you contribute $10,000 per year your employer contribution will be $5,000 so you’ll end up with $15,000.

How is a 401(k) plan taxed?

There are two main kinds of 401(k) plans: traditional and Roth.

Traditional: You don’t pay federal income tax on a traditional 401(k) plan contributions until you withdraw from the account. That means investments grow tax-free.

Roth: Contributions to a Roth 401(k) are made after taxes. When you withdraw, the funds won’t be taxed because you contributed with post-tax income.

An Individual Retirement Account (IRA) is opened by an individual, usually through an investment firm, bank, insurance company or broker. A 401(k) is opened and managed by an employer. Under IRS rules, contribution limits are higher for a 401(k) than for an IRA.

The limit for employer-sponsored 401(k) plans in 2022 is $20,500 after the IRS raised the limit by $1,000 last year. That’s far higher than the $6,000 maximum for traditional and Roth IRAs.

Can you withdraw from your 401(k) account without a penalty?

In general, taking money out of a retirement plan before reaching age 59 ½  comes with a penalty. The IRS calls this move an early – or “premature” – distribution. You’ll wind up paying a 10% tax on the early withdrawal unless you qualify for an exception.

Can you take out a loan against your 401(k) plan?

If your plan allows it, you can borrow up to $50,000 or half your vested balance. Most plans give borrowers up to five years to pay the loan back – with interest.

Be careful, though: if you lose your job and don’t repay by that year’s tax deadline, the IRS considers your loan a withdrawal. That means if you’re younger than 59 ½, you might have to pay the 10% early withdrawal tax penalty.

What happens to my 401(k) if I change jobs?

Most payments to your 401(k) plan can be “rolled over” to another 401(k) plan or an IRA within 60 days. You can ask your financial institution or plan administrators to directly transfer the payment. You generally won’t pay taxes on the funds until you withdraw from the new plan.

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