What is a 401(k) plan?

401(k) plans got their name from a section of the federal tax code enacted by Congress in 1978, and have become the most popular type of workplace retirement savings plan. These defined contribution (DC) plans differ from pension plans, also known as defined benefit (DB) plans, which were common in the past but are increasingly rare today. In a DB plan, the employer makes all contributions to fund an employee’s retirement. With 401(k)s and other DC plans, most responsibility falls on employees to contribute to their retirement savings.

Most 401(k) providers offer an employer match, meaning the company will contribute an annual percentage of eligible employees’ compensation to their 401(k) account. One popular matching formula is 100% of the first 6%—where employers contribute as much as employees contribute, up to 6% of their salary; if employees contribute 3%, employers match 3%; and if employees contribute 8%, employers contribute 6%. With the match, employers provide a generous incentive to save for retirement.

Automation makes it easier to save

A 401(k) plan can help automate the retirement savings process through automatic payroll deductions. Employees in some plans can also choose to automatically increase their contribution by a certain amount every year.

Tax treatment in a 401(k)

Contributions to a 401(k) plan are most commonly made through pretax¹ payroll deductions. 401(k) pretax contributions reduce taxable income and grow tax free until they’re withdrawn, typically at retirement. Allowing contributions to grow tax free over long periods may add up to a larger balance at retirement. For example, an employee with a $10,000 account balance making $1,000 in annual contributions for 20 years at an average annual rate of return of 8% would end up with more than $23,000 in a tax-deferred account than in a taxable one.²

Many plans also offer options for employees to make post-tax 401(k) contributions from their paycheck. Post-tax contributions don’t lower an employee’s taxable income, but they do grow tax free and aren’t taxed on withdrawal.³

The power of compounding

Investing their retirement contributions gives employees the opportunity to grow their contributions. Earnings from those contributions can then be used to make additional investments, which can generate increased earnings, a process known as compounding. This calculator shows you how much your savings may grow over time, thanks to the power of compounding.

Contribution limits

Employees have the flexibility to choose their contribution percentage and may contribute up to a maximum of $19,000 per year to their 401(k) account. 401(k) contribution limits are higher for employees aged 50 or older, who may make an additional catch-up contribution of $6,000.⁴

401(k) plans offer participants a wide range of mutual fund and similar investment choices through a carefully chosen investment lineup. Participants can choose investments based on their investment preferences and experience, time until retirement, and tolerance for risk. Participants who lack the time or knowledge to select individual investments can choose investment options that offer a professionally allocated mix of funds. All-in-one 401(k) investment options you’re most likely to see include:

• target-date funds (TDFs), which automatically adjust an allocation to stocks, bonds, and cash over time based on the participant’s retirement date; and
• target-risk funds, which base an allocation to stocks, bonds, and cash on the participant’s risk tolerance.

Some plans offer a qualified default investment alternative, usually a TDF or target-risk fund, that becomes participants' investment option if they don’t select one on their own. Plans may also offer managed accounts, which carry higher costs but allow participants to benefit from a personalized portfolio and professional guidance by a qualified investment advisor.

Contributing to a 401(k) plan can help participants prepare for retirement. By participating in their company’s 401(k) plan, employees can take advantage of matching contributions from their employer, enjoy preferential tax treatment on both pretax and post-tax contributions, harness the power of compounding, and gain access to a wide range of investment options. Check out this article for even more reasons to get started today. 

1 Limits are for 2019 and can be subject to change annually. 2 Ordinary income taxes are due on withdrawal. Withdrawals before the age of 59½ may be subject to an early distribution penalty of 10%. 3 This is a hypothetical illustration used for informational purposes only. The marginal tax bracket used is 25%. This lump-sum, after-tax figure doesn’t account for the possible change in tax bracket that might occur due to a lump-sum distribution of the taxable amount, nor does it take into effect any applicable tax penalties. There is no guarantee that the results shown will be achieved, and the assumptions provided may not be reflective of your situation. 4 Only applies to qualified distributions, which means the money is withdrawn when you are at least 59½ years old, or on death or disability, and you’ve held Roth contributions in your account for at least five years (some exceptions apply).