What is a 401(k)?

A 401(k) is an employer-sponsored retirement account that encourages people to save by offering significant tax advantages. If it is an option for you, it can be a powerful retirement savings tool.

What is a 401(k), and how does it work?

A 401(k) is a savings plan offered by employers to help employees save for their retirement years. Employees put money into an account, and it grows over time with tax-advantaged savings. Most 401(k) plans offer several mutual funds and/or exchange-traded funds (ETFs) in which contributions can be invested. In retirement, participants can withdraw money in regular increments, which gives them a stable income in their golden years. Here is what makes a 401(k) special:

The power of compounding interest

A compelling reason to save via a 401(k) is the power of compounding interest. The money you contribute to your account has the potential to grow exponentially over time. As earnings are reinvested and generate even more earnings and as new contributions are invested, the account becomes worth more and more. And because taxes are deferred, there’s even more money to compound. This is especially true if you start saving early. In fact, a single dollar saved today can grow to as much as $50 or more by the time you reach retirement.¹

Many companies match contributions

One of the most significant advantages of a 401(k) is that many employers offer a matching contribution, often a 25%, 50%, or even 100% match of your contributions up to a limit, usually between 1% and 6%. For example, let’s say your employer match is 50% on up to 6% of your salary. If you contribute $360 per month (6% of your $72,000 a year salary), your employer will add $180 to your 401(k)—an immediate 50% return on your investment. This match is essentially free money that can significantly boost your retirement savings, so it's important to take full advantage of this benefit if it's available.

What happens if you leave the company offering the 401(k)?

When you leave a company, the money you contributed to your 401(k) and any earnings on it are yours, but you will no longer be able to make contributions to that 401(k). Based on your individual circumstances, you have several options such as taking a cash distribution, leaving your retirement savings where they are, or doing a rollover to your new employer’s plan or an IRA. Many people roll that money over into another investment account, but if you’re happy with the plan’s investment options, you can leave your money where it is. Sometimes, you must stay at a company for a certain number of years to claim the full company 401(k) match. It’s important to understand your employer’s rules around matching and vesting since policies vary from company to company. Examine the documentation your company provides carefully.

Traditional 401(k)s:

With a traditional 401(k), your contributions are made with pretax dollars, which means you don't pay current income taxes on the money you put into the account. That lowers your tax burden in the year that you make the contribution. For example, let's suppose you earn $60,000 a year and contribute 6% of your income ($3,600 a year) to your traditional 401(k). Your taxable income for the year will be reduced to $56,400, potentially lowering your tax bill.

Contributions are usually withdrawn directly from your paycheck, so nothing extra is required of you after you set your contributions and choose among your investment options. The funds will grow tax-deferred over time. Then, when you retire, any withdrawals will be taxed as ordinary income.

Roth 401(k)s

A Roth 401(k) is different from a traditional 401(k) in that your contributions are made with after-tax dollars. You won't get an immediate tax deduction for your contributions, but growth on your Roth 401(k) will be tax free, as will qualified withdrawals during retirement. This can be especially beneficial if you anticipate being in a higher tax bracket during retirement or want more flexibility in managing your taxes during your golden years. In addition, the rules around early withdrawals are more lenient with Roth 401(k)s.

Not all employers offer Roth 401(k)s, so check with your HR department to see what your options are.

401(k) contribution limits

There is a maximum, set by the IRS, that you are allowed to put into 401(k)s each year. The maximum annual contribution for a 401(k) in 2023 is $22,500 for individuals under 50; those age 50 and above can make an additional $7,500 in extra “catch-up” contributions.²

The contribution limits for Roth 401(k)s are the same as those for traditional 401(k)s. The total combined contribution to both types of accounts must not exceed the annual limit.

401(k) withdrawal rules

Withdrawing funds from a 401(k) plan can be a complicated process, as there are many rules and regulations to consider. It is essential to remember that all withdrawals must be reported on your tax return.

Withdrawals from your 401(k) before the age of 59½ are generally subject to a 10% early withdrawal penalty tax on top of income taxes. There are certain exceptions, however. If you have a disability, have unreimbursed medical bills, or are making a down payment on a house, the penalty tax may be waived. But income taxes will still be owed on withdrawals from a traditional 401(k). Taxes could also be owed on distributions taken from a Roth 401(k) before age 59½.

Once you reach the age of 59½, you can start making penalty tax-free withdrawals from your 401(k). If it’s a traditional 401(k), these withdrawals will be counted as income and taxed appropriately. If it’s a Roth 401(k) and you have had the account for five years or more, the withdrawals will be tax free.

With a traditional 401(k), required minimum distributions (RMDs) must begin at age 73 unless you are still employed by the company that sponsors your plan. (For those who reached age 72 on or before December 31, 2022, they began at age 72.) This means you must start taking out a required percentage of your retirement savings each year, or you could face penalties.

Comparing traditional and Roth 401(k)s

While both offer tax-advantaged savings, there are key differences that could mean one type is better suited to your needs than the other. The primary difference between a traditional and a Roth 401(k) is that the former is funded with pretax money while the latter is funded with post-tax money. Roth 401(k)s also have fewer rules about early withdrawals. Here are the key differences:

Is a traditional or a Roth 401(k) right for me?

Many employers’ plans now offer the opportunity to contribute both to a traditional and Roth 401(k) plan.  When deciding between a traditional and a Roth 401(k), it’s important to consider your future income tax rate. If you anticipate that your future tax rate will be higher than your current one, contributing to a Roth account may be more beneficial, since the money can be withdrawn without incurring taxes in retirement. However, it’s more common for retirement tax rates to be lower than tax rates while working. So, contributing to a traditional account will make more sense for more people.

Conversion options between traditional and Roth 401(k)s

In some cases, you may have the option to convert funds from a traditional 401(k) to a Roth 401(k) or a Roth IRA through a process known as a Roth conversion. This can be beneficial if you want to take advantage of tax-free withdrawals later in life or if you anticipate lower income during a particular tax year. 401(k)s are just a part of a robust retirement plan. A trusted financial professional can help you make decisions and can offer guidance on how best to maximize your savings.

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Investments are offered through NYLIFE Securities LLC (member FINRA/SIPC), a Licensed Insurance Agency and a New York Life Company.

Neither New York Life Insurance Company nor its agents provide tax, legal, or accounting advice. Please consult your own tax, legal, or accounting professional before making any decisions.

¹Return based on $1 invested for 40 years with 10% growth compounded monthly.

²“401(k) limit increases to $22,500 for 2023, IRA limit rises to $6,500,” IRS.gov, October 2022.