How Does A 401(k) Work?

You’ve probably heard the term 401(k) at least a thousand times, and you might even have some of your own money invested in one.

But exactly what is a 401(k)?  And how does a 401(k) work?

Those are the questions we’re setting out to answer here. And we’re going to answer them in plain English, so by the time you reach the end of this guide you’ll be an official 401(k) expert!

Lego man with map acting as a 401k guide and explaining how does a 401k work

Now, I’m not a financial advisor, but I do work in the 401(k) industry in my day job. That industry background means I understand 401(k) plans better than most people.

Sadly, that’s not saying much.

In my experience, the average American barely understands how a 401(k) works.

And the financial services industry doesn’t exactly make it easy for you to understand, does it? It’s in their best interest to keep you confused so you’ll continue to pay them for advice.

Just take a look at the 401(k) paperwork they gave you when you started your job and tell me how helpful it is.

If it’s like most documents I’ve seen it uses complicated jargon written by lawyers who like to make things as confusing as possible.

But that doesn’t really help people like you me, does it?

You don’t have time to read through the hundreds of pages of paperwork that makes up your enrollment package, summary plan description, deferral election form, beneficiary designation form, fee disclosure, and investment option paperwork.

What you need is a simple 401(k) guide that explains everything to you in straightforward, easy to understand language.

And that’s why I created this guide.

But this is more than just a 401(k) for dummies type of post. My goal is to make this the ultimate resource for people who have questions about how a 401(k) works.

Rather than make one ridiculously large page that would take forever to read, we’ve broken it up into chunks. On this page you’ll find some 401(k) basics which will help you get started. And near the bottom are links to other sections of the guide which cover various aspects of 401(k) plans.

Now before we get too far, let me make a couple of quick points about this guide.

First, when a company is first setting up a 401(k) plan they have many different options to choose from, which means not all plans are created equal.

Think of it like the difference in cars. Your car might have a moon roof, a luggage rack, and leather seats. I could have the same model but without any of those extra features.

Same basic car, but very different in several important ways.

The same goes for 401(k) plans and since there is an almost infinite variety of options, I can’t possibly go over every single combination.

Instead, I’ll go over the most common features with the understanding that some of the sections below may not apply to your individual situation.

Secondly, I am not a financial advisor and anything I say is strictly my own opinion and shouldn’t be taken as advice.

What Is A 401(k) Plan And How Does It Work?

In simple terms, a 401(k) plan is a type of savings plan that allows you to set aside a portion of your paycheck and invest it for retirement.

Contributions are automatically deducted from your paycheck before taxes so you get a tax break with each contribution you make.

As long as you keep the money within the 401(k) account you won’t pay any taxes until you retire and withdraw the funds.

SIDE NOTE – 401(k) isn’t the sexiest of names, and people often misinterpret it as 41K plan or a 4o1k plan.  The 401(k) got its super exciting name from the section of the Internal Revenue Code that explains it. So, the next time you have nothing better to do, grab a copy of the Internal Revenue Code and turn to Section 401(k) so you can see for yourself.

401(k) Eligibility Rules

You can’t just go to a bank or a website and sign up for a 401(k) on your own.  Your employer has to decide to offer a 401(k) to its employees.

If you work for a very large company you almost certainly have access to a 401(k) plan.  But smaller companies may not want to be bothered with the hassle or added expense of offering a 401(k).

And even if your company does have a 401(k) plan, you might need to meet age and service requirements before you become eligible to participate.

In general, you must be allowed to participate in the 401(k) plan as long as you’ve reached age 21 and have at least one year of service with your employer.

Keep in mind those are the maximum requirements you may need to meet.  Your employer may not have any age or service requirements at all, or they may set them at something less than 21 and 1 year.

For example, they might limit the plan only to employees who are over 18 and have worked at the company for 6 months.

Some plans do exclude entire classes of employees no matter how old you are or how long you’ve worked there.  Union workers and part-timers are types of employees who are often excluded from 401(k) plans.

How To Enroll In A 401(k) Plan

Once you become eligible to join your company’s 401(k) plan, you should receive an enrollment package containing some important documents including:

  • A summary plan description outlining how the plan works
  • A salary deferral election form so you can choose how much you want to contribute and which funds you want to invest your money in
  • A beneficiary designation form to indicate who will receive the assets if you die. If you are married this will be your spouse

You might receive an actual paper package containing these documents, but these days most employers allow you to enroll into the 401(k) plan online.

Some plans don’t even require you to enroll in them.  They will actually sign you up automatically unless you tell them not to.

This is called negative enrollment or automatic enrollment.

Those people who never took the time to read through the documents and notices they received are often surprised when they notice their paycheck gets smaller and money starts going into their 401(k) plan.

Fortunately for them, they typically have an option to withdraw your money within a 90 day window beginning with the date of the first automatic contribution.

How Much Can I Contribute To A 401(k) Plan?

The government wants you to save for retirement.  That’s why they offer tax savings on any contributions you make.

But they don’t want you to save too much, right?  They still need a healthy dose of tax income to keep the country running.

So, they put a limit on how much you’re allowed to contribute to a 401(k) plan.

In 2020, the 401(k) contribution limit is $19,500.  If you’re 50 or older you can make an additional catch-up contribution of $6,500 for a total of $26,000.

That’s just the money you contribute yourself. If you include employer contributions the limit jumps all the way $57,000 ($63.500 including catch-up contributions) .

More About 401(k) Plans

The articles below will give you everything you need to know about 401(k) plans:

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