What is a 401(k) plan?

When it comes to retirement planning, various savings options are available. One of the most popular retirement savings options is the 401(k) plan. What is a 401(k) plan? Simply put, a 401(k) is a retirement savings plan that’s sponsored by an employer. The only way to open a 401(k) account is through an employer who offers one.

But there’s more to 401(k) plans than meets the eye. As you begin to think about and prepare for retirement, it’s important to know how 401(k) plans work and what their benefits are. Throughout this guide, we’ll dive into the ins and outs of 401(k) plans, so you can better understand how they can help you save for retirement. Read through to learn all about 401(k) plans, or use the links below to navigate throughout the post.

What is a 401(k) plan?

401(k) plan is a qualified plan that allows employees to have their employer contribute a portion of their paycheck to a retirement savings account. When we say “qualified,” it means the plan is eligible for tax benefits under IRS guidelines. The term 401(k) comes from subsection 401(k) of the Internal Revenue Code , which outlines the rules surrounding this type of retirement plan. Depending on the type of 401(k) plan you have, your tax break comes when you either contribute money to the plan or withdraw funds in retirement.

A common FAQ is, “how does a 401(k) actually work?” If your employer offers a 401(k) as a benefit, you can have them dedicate a percentage of your income toward a retirement account using pre-tax dollars. Inside this account, your money will be invested in various vehicles, such as stocks, bonds, and mutual funds, which you can often pick yourself.

Contributions made to a 401(k) plan will show up on a W2 Form for employees. As an employer, you should keep accurate payroll records and payroll reports to ensure all contributions are reported for tax purposes.

In some cases, your employer might offer an additional benefit by matching your 401(k) contributions. Matching contributions means they’ll match “X” amount of cents on every dollar, up to a certain limit. For example, a recent Vanguard study found that about 51% of employers offer a 401(k) match. Of those employers, here’s how they match:

  • Single-tier formula: 70% of companies offered a 50% match, up to 6% of their salary
  • Multi-tier formula: 20% of companies offered a 100% match on the first 3% and an employee’s salary, then a 50% match on the next 2% of an employee’s salary
  • Dollar cap: 6% of companies offered a single or multi-tiered formula with a $2,000 maximum
  • Other: 2% of companies offered a variable formula based on age, tenure, or similar variables
Types of matching contributions

What’s so attractive about employer 401(k) matches is that it’s virtually free money your employer contributes to your plan. However, once you either reach retirement or no longer work for the company sponsoring your 401(k) account, you won’t receive a match.

What is the difference between a 401(k) and a Roth 401(k)?

As we’ve alluded to, there are different types of 401(k) plans. The two most popular are traditional 401(k) plans and Roth 401(k) plans. We’ll stick to traditional 401(k) plans throughout this post, as they’re the most basic and common 401(k) type. However, to save you from confusion, we’ll go over the differences between traditional and Roth 401(k) plans.

Traditional 401k vs Roth 401k

Traditional 401(k) plans provide retirement benefits to employees. Each paycheck, employees can have their employers direct a portion of their pay to their retirement account. These pre-tax contributions are then invested in various securities like stocks, bonds, and mutual funds. The money put into a traditional 401(k) along with any earnings are tax-deferred. This means income taxes are only applied when you withdraw funds during retirement. The benefit of a tax-deferred account is that postponing taxes on earnings generated can allow more returns to compound over time.

A Roth 401(k), on the other hand, is very similar to a traditional 401(k). The one major difference lies in how contributions and earnings are taxed. Contributions made to a Roth 401(k) are made after-tax dollars. This means you’ll pay income taxes on the money you put into your Roth 401(k). The benefit of a Roth 401(k) plan is that withdrawals made in retirement are completely tax-free, along with any interest, capital gains, or dividends made. Roth 401(k) plans are often best for higher-income earners or those who believe they’ll be in a higher tax bracket when they retire.

Benefits of opening a 401(k)

Now that you know what a 401(k) plan is, let’s look at some of the advantages of contributing to one. Some of the main benefits of opening a 401(k) include:

Benefits of opening a 401k
  • Tax breaks: Because contributions made to a traditional 401(k) are tax-deferred, your taxable income for the year is lowered. For example, if you make $60,000 and contribute $15,000 a year, your taxable income will be $45,000. In addition, your savings grow tax-deferred, so any money made on interest, dividends, or capital gains aren’t taxed. However, once you reach retirement and make withdrawals, withdrawals will be taxed as ordinary income. On the other hand, with a Roth 401(k), taxes are taken care of upfront, so you won’t pay taxes on any earnings made when you withdraw in retirement.
  • Lower tax bracket: With reduced taxable income, you might be pushed into a lower tax bracket for the year. This means you could have a smaller tax bill for the year.
  • Shelter from creditors: If you find yourself in financial trouble, you don’t have to worry about creditors going after your retirement savings in your 401(k). This is because the Employee Retirement Income Security Act of 1974 prevents claims by creditors.
  • Employer match: One of the highly sought benefits of 401(k) plans is the employer match. Not every employer offers one, but if they do, you’re practically receiving free money. To maximize your earnings, contribute up to your employer’s contribution limit. For example, if they agree to make a 1:1 match up to $6,000 of your salary, try to contribute $6,000 for the year. This way, your 401(k) account will have $12,000 in it for the year.
  • High contribution limits: The IRS sets contribution limits for participants in 401(k) plans. The contribution limit for 2020 was $19,500 and remains the same for 2021.
  • Contributions after age 72: For most retirement accounts, you need to take required minimum distributions (RMDs), which is a minimum amount you need to take each year. However, with 401(k) plans, you can continue to contribute to your 401(k) plan as long as you are still working and owe less than 5% of the company.

401(k) contribution limits

The IRS sets contribution limits each year for the amount of money you can put in your 401(k). The contribution amounts go as follows:

  • 2021: $19,500
  • 2020: $19,500
  • 2019: $19,000

The contribution limit is typically adjusted each year for changes in the standard cost of living. However, employers have the ability to set a cap below the IRS’s contribution limits. The IRS also allows for “catch-up” contributions for those aged 50 or older. The catch-up contributions are as follows:

  • 2021: $6,500 ($26,000 total)
  • 2020: $6,500 ($26,000 total)
  • 2019: $6,000 ($25,000 total)
401k contribution limits, catch-up contribution limits

Employer matching

As you know, one of the main benefits of 401(k) plans is the employer match. Employers aren’t required to match your contributions, but if they do, it can be seen as free money. Taking advantage of your employer contributions is a great way to maximize your contributions and grow your retirement savings over time.

Let’s look at an example. Say your employer offers a 50% match on 6% of your annual salary, and your salary is $60,000. By taking 6% of your salary, you’ll come up with $3,600. This is how much you’ll need to contribute to receive the full benefits of your employer’s match. With a 50% match, that means your employer will contribute $1,800 each year to your 401(k) plan.

How to invest your 401(k)

401(k) plans typically have limited investment options that are dictated by your plan provider and employer. With a 401(k) plan, you’re not investing in individual stocks and bonds but mutual funds, and in some cases, index funds and exchange-traded funds. These funds place your money in a basket of securities rather than an individual stock or bond.

When investing in your 401(k), it’s important to keep your risk tolerance in mind. Stocks are typically the riskiest investment, while bonds and other fixed-income investments are more secure. Typically, it’s advised to invest in riskier investments while you’re young and slowly tone it down as your near retirement. A general rule of thumb is to subtract your age from 110 to determine the percentage of your 401(k) that should be invested in equities. Then, invest the remaining percentage in bonds.

However, this is just a rule of thumb, so you should consider how much you’re comfortable with losing should the stock market crash.

Rules for withdrawing from your 401(k)

The government encourages people to save for retirement by offering tax benefits for qualified retirement accounts, such as 401(k) plans. To prevent contribution plan owners from withdrawing early from their 401(k), they can’t take qualified distributions until they reach the age of 59½. If an account owner makes a withdrawal that doesn’t meet the qualified distribution requirements, they will face an early withdrawal 10% tax penalty on the money withdrawn.

However, there are certain exceptions to the 59½ age limit. A 401(k) participant can withdraw before they reach this age in certain situations. Some scenarios include:

  • The death of the account owner
  • The account owner suffers a total and permanent disability
  • The owner has unreimbursed medical expenses in an amount greater than 10% of their adjusted gross income (AGI) for 2021, or greater than 7.5% of their AGI for 2017–2020
  • Immediate and heavy financial need

401(k) plan loans

If your employer allows, you can take out a 401(k) plan loan, which could be used for purchases like a home, car, or paying off debt. To qualify for a 401(k) plan loan, the loan must meet certain eligibility requirements, which go as follows:

  • The maximum loan amount a participant can borrow from their plan is 50% of their vested account balance or $50,000—whichever is less
  • The employee must repay the loan within five years in quarterly payments

The benefit of 401(k) plan loans is that you’re able to secure financing for larger purchases, such as a home. However, if you need more than the loan limits, you can’t take more money out of the account. If you do, you could face legal repercussions, such as facing a 10% early distribution tax.

Before borrowing from your retirement account, it’s best to consult with your financial advisor for investment advice and to determine whether other options are available.

Post-retirement 401(k) withdrawal rules

Once you reach retirement at the age of 59½, you’re able to withdraw from your 401(k) penalty-free. With a traditional 401(k), you will have to pay income taxes on the funds withdrawn from the account. However, if you want your savings to continue to grow, you don’t need to withdraw right away. Retirees have until 72 (70½ if you reach age 70½ before January 1, 2020). Once they reach this age, they will have to take RMDs. RMDs are the minimum amount retirees must take from a qualified retirement account.

How to roll over your 401(k) money

In some cases, you may be looking to roll over your 401(k) into another retirement fund. This usually happens when you switch employers or want to go from a traditional 401(k) to a Roth IRA to receive different tax benefits. There are four main ways to roll over your 401(k) money:

How to roll over your 401k
  • Keep your 401(k) with your old employer
  • Roll over your 401(k) into an IRA
  • Roll over your 401(k) into your new employer’s 401(k) plan
  • Cash out your 401(k)

To roll over your 401(k) money, you can ask your plan administrator for a direct rollover where they will place your money in a new retirement account. In some cases, you might get a 60-day rollover where the cash is sent directly to you. If that happens, you have 60 days to deposit all or part of your retirement savings into your new retirement account. If you fail to do so within 60 days, you can face a withholding fee.

It’s important to keep in mind that certain scenarios can come with hefty penalties. For example, if you cash out your 401(k), you can face a steep 10% withholding fee along with your income taxes.

Final thoughts

Short on time? Keep these key points in mind:

  • 401(k) plans are employer-sponsored retirement plans that direct a portion of an employee’s income into stocks, bonds, mutual funds, and other securities.
  • There are numerous benefits of 401(k) plans, such as tax breaks, shelter from creditors, employers matching an employee’s contribution, and more.
  • Employees can contribute up to $19,500 to their 401(k) plan in 2021.
  • 401(k) participants can’t withdraw from their account until they reach the age of 59½, unless they meet the criteria for certain exceptions.
  • 401(k) plan owners can rollover their 401(k) into a new employer’s 401(k) plan or an IRA.

As you get into payroll withholding, QuickBooks can help. Our payroll software for small businesses can help you understand how to report employee retirement contributions, how to reconcile payroll and more.

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