How Exactly Does a 401(k) Work?


A 401(k) plan is a specific type of retirement savings plan designed to offer participants a tax benefit for setting aside money for retirement. These plans are employer-sponsored, meaning that companies set them up and administer them on behalf of employees, although self-employed persons can establish personal, or "solo", 401(k) plans, too. Because the plans are designed for retirement savings, certain rules and restrictions apply to deposits and withdrawals. Participants may be penalized if they do not follow these rules.

Sign up for your company 401(k) plan. Plan participants must be at least 21 years of age to begin saving. In addition, some companies may require employees to work for a certain number of months or years prior to being eligible to participate.

Designate a specific amount of money you would like withheld from each paycheck. In most cases, you choose between a dollar value or a percentage of pay to be automatically deposited to your 401(k) account each pay period.

Select an investment array. Most employers allow employees to choose specific investments for their savings via an online website, toll-free number or paper form. These investments are often mutual funds, but may involve other options. Take time to review your investment options thoroughly – read prospectuses, annual and quarterly reports – before making your decisions.

Add to your savings automatically each pay period. Your employer may also add a matching contribution, based on your contribution. In a traditional 401(k), all of these contributions are subtracted from your taxable pay, so you pay less tax each year.

Perform an investment review each year. Make sure your investments are performing as you'd like, and make any adjustments to account for changes in your long term goals. While most plans allow participants to make changes whenever they'd like, some plans limit investment changes to certain periods of the year. Verify your company's policy with your plan administrator.

Begin taking regular withdrawals from your 401(k) account once you reach retirement age. This is any time after age 59 years and six months, and before age 70 years and six months. You have flexibility in how you take distributions for the first 10 years – take some as needed, or take regular monthly, quarterly or annual withdrawals. Once you reach age 70 years and six months, however, you must take a proscribed minimum amount each year. See IRS Publication 575 for specific calculation information. Your plan administrator provides the forms you use to request these withdrawals and set up a payment method.

Pay income tax on the amount you withdraw from your 401(k) account each year. Since you didn't pay income tax on this money when you received it, you need to pay it as you withdraw it in retirement. Assuming you do not take your money early, your 401(k) withdrawals are only subject to ordinary income tax. Find the specific tax information on the IRS Form 1099-R that you receive from your plan administrator. This form usually arrives in the mail in early February.

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