A 401k is a retirement plan offered by many U.S. companies to employees. The name 401K comes from the section of the Internal Revenue Code governing the retirement plan.
The biggest benefit of a 401k plan is that the contributions are pre-taxed. This means the money you deposit in the plan isn’t taxed until you withdraw the money, hopefully at retirement. Money in a 401K plan can earn interest and grow tax-deferred.
When you enroll in a 401k plan money is automatically deducted from an employee’s paycheck and deposited into the plan.
Most 401K plans allow you to invest in stocks, mutual funds, bonds, money markets, annuities, guaranteed investment pools, company stock or hybrids (i.e., mutual fund that invests in stocks and bonds) of these instruments. Most 401K plans will offer a list of different investment instruments to pick from and may rank them based on risk.
Some companies, mostly large companies, will entice employees to invest in 401k plans by offering a company match. Employers will contribute additional money into an employee 401k account that matches a portion of their contribution. Some companies will match dollar-for-dollar up to certain percentage, while others will match a specified percentage of an employee contribution. The current contribution limit for employers is 6% of the employee’s pre-tax compensation.
Some companies have a vesting period for when an employee will get the money matched in their plan. As an example, a company may require for an employee to be employed at the company for at least 5 years to be vested; meaning the employee will get all the company match dollars deposited into their account. If the employee leaves before the 5 years, they may lose all matched dollars or get an amount that is pro-rated based on years of service.
Money is generally withdrawn from a 401k plan for 5 reasons: retirement, reaching age 59 1/2, termination of employment, disability or death. Some plans allow employees to borrow money from their account and pay themselves back with interest.
Maximum and Catch-Up Contributions
Currently, the maximum dollar amount by law an employee can contribute to their 401k plan from pre-tax pay is $16,500 per year and the catch-up contribution limit is $5,500 per year. Catch-up contribution allows plan participants that reach age 50 before the calendar year is over to make additional catch up contribution limits on a pre-tax basis.