Investing 101

An Introduction to the 401(k)

Written by Mint
Published Aug 25, 2020 - [Updated Jun 1, 2022]
4 min read
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Before investing in a retirement plan it will be highly beneficial for employees to understand what’s a 401k and how it works for them. The traditional 401k is one which employers provide to their workers by taking some money out of each paycheck to contribute to their personal account. In addition, many participating employers also contribute money to the worker’s 401k plan, often matching the employee’s contribution. When employers match their employees’ contributions, this is called a matching 401k. The traditional 401k is a stock investment plan, which means the money invested in a 401k is used to buy a set of stocks for an investment portfolio. When an employee invests in a pre-tax 401k plan, they incur some tax benefits, which include not owing any Federal income taxes on income that is invested in the 401k. In addition, money is automatically added to the employee’s 401k account from each paycheck, so they aren’t required to take action to ensure contributions are properly made. The ultimate purpose of a 401k is that it is a pension plan, which means that it is income that workers set aside for their retirement years. The goal of a 401k is to ensure that retired people do not have to worry about making ends meet in their later years of life.

The term 401(k) refers to a pension and profit sharing plan that is based on a defined contribution system. It is named after a section in the IRS tax code which came into existence through the Revenue Act of 1978. Even though financial planners were aware of the new Revenue Code 401(k), it wasn’t until 1981 that the IRS explained the rules for taking advantage of the new system. In the beginning, few companies offered this benefit to their employees, but by 2005, the 401k defined contribution pension plan became the most common private-market retirement plan offered by employers in the United States. By that time, the total nationwide value of all 401k plans combined, reached over two trillion dollars.

A major part of knowing what is a 401k plan involves knowing how it is funded. Employees participating in a 401k plan typically choose their investment vehicles, or what they invest their 401k funds into. These investments usually mean stocks, but investment vehicles can also be bonds, mutual funds, exchange traded funds, or derivatives. When employers pay into to the plan, it is called a profit sharing plan. In this case, employees may or may not be required to match the employer’s contribution to their 401k plan. There are limits to how much employees and employers can contribute to a person’s 401k, however. According to IRS law, an employer can only contribute twenty-five percent of the employee’s yearly income. The individual, on the other hand, can contribute up to $50,000 of their annual income to their 401k as of 2012, or the equivalent of their yearly salary, if it is under $50,000.

While 401k account holders do not get assessed taxes for the income that they put into their 401k at the time of contribution, there are restrictions that apply. Withdrawing money from one’s 401k plan before the age of retirement incurs a tax penalty of ten percent. This can be waived under certain hardship-related situations. This includes the employee’s death or complete and life-long disability, or when they need the money to pay for certain qualified medical emergencies. Upon retirement, money withdrawn from one’s 401k plan is taxed as ordinary income.

By Kelly Anderson

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