A complete guide to 401(k) retirement plans: What is a 401(k)?

If you’re working and already saving for retirement or plan to start socking away money soon, investing in a 401(k) plan can help you build a sizable nest egg.

If you’re thinking about signing up for a 401(k), or simply want to know more about how to take full advantage of this type of retirement savings vehicle, here’s everything you need to know.

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

A 401(k) plan is a tax-advantaged retirement savings tool offered by employers that allows eligible employees to contribute a portion of their salary up to a set amount each year.

Unlike traditional pension plans, in which the employer promises a specified monthly benefit at retirement, 401(k) plans are funded by contributions deducted directly from the employee’s paycheck. Many companies match contributions up to a certain percentage of your annual salary, say 4 or 5 percent, which is one of many notable 401(k) benefits.

Getting started with a 401(k)

While 401(k) plans are broadly similar, each employer’s plan can differ in important ways, such as whether you can take a loan against your savings or the types of investments available. Here are some key things to understand about your plan as you get started:

• What are your company’s eligibility requirements and will you automatically be enrolled in the plan?
• Will the plan automatically increase your contribution each year?
• Does your company offer a matching contribution and how much is it?
• What investment options does the plan offer? What do they cost and are those funds expensive relative to other available options?
• Does the plan offer any third-party advice (such as from the plan’s administrator) or any option to have the account managed for you?
• Can you invest in individual securities or do you have to stick to the funds provided in the plan?
• Can you take a loan against your account balance? How much does the loan cost?

These are a few of the most important questions that you’ll want to answer as you get started with your 401(k). Don’t assume that all plans are alike because your employer may change important aspects of the plan – even beyond the basics, such as its matching contribution.

How much should you contribute to your 401(k)?

When it comes to how much of your pay you should contribute, everyone has different financial needs in retirement, but there are some general rules you can follow.

Contribute enough to take advantage of any matching dollars offered by your employer, says Catherine Golladay, former managing director at Charles Schwab.

Whether your company match is dollar-for-dollar or something smaller, such as 50 cents on the dollar, don’t pass up the match. “Not doing so is like leaving money on the table,” she says.

After saving enough to get the full employer match, Golladay suggests paying off high-interest debt and building an emergency fund. Then, go back and maximize tax-advantaged retirement accounts, either the 401(k) or retirement accounts such as an individual retirement account (IRA) or Roth IRA.

About 70 million Americans invest in 401(k)s and these retirement plans hold $6.9  trillion in assets, according to the Investment Company Institute, citing data as of September 30, 2023 . Plan participants can roll up substantial savings over the years of their working lives. Here’s how much the average American has in a 401(k) by age.

Bankrate’s calculator can help you decide which tax-advantaged account to stash additional funds in.

Most 401(k) plans have at least three investment choices, though others offer many more options. The average plan offers about 13 investment options, according to the Investment Company Institute. The menu could include a mix of investments, such as mutual funds, company stock and index funds, as well as stable value funds (or cash), bond funds and so-called “target date” funds, which adjust your portfolio based on your years until retirement.

Fortunately, while you can pick your own funds if you’re the do-it-yourself type, you often don’t have to decide how to invest completely on your own.

“Many of today’s 401(k) plans include professional investment advice, which can be key in helping the participant make investment decisions based on their overall financial picture,” Golladay says.

Target-date funds (TDFs) have become popular options because they automatically adjust the mix of investments over time to align with investors’ risk tolerance as they approach retirement. For example, they move money from higher-risk stock funds to lower-risk bond funds as you near retirement, so that you have a more stable portfolio when you need the money.

While target-date funds meet many investors’ demands, they don’t fit every individual’s needs.

“While a TDF can be effective, a more tailored portfolio based on multiple data points about the investor may be the best option for some,” Golladay says.

Before you can decide how to allocate your contributions, determine your risk tolerance. It’s critical to know how well you can deal with volatility in your portfolio. You want to make sure you can sleep at night if financial markets turn turbulent and asset prices fall. But keep in mind that markets historically have recovered even after brutal bear markets, or stock market declines of 20 percent or more, which are typical during recessions.

Here are five other ways that you can maximize your 401(k) over time and generate higher returns.

How to choose investments for your 401(k)

Here are some smart moves to make with your 401(k), including how to earn a higher return by being aggressive with your investments and when not to:

• Design your investments with your age in mind. Avoid being too conservative when you’re younger and too aggressive when you’re old
• If you’re in your 20s or 30s, you can afford to be more aggressive with your investments – investing more or all of your money into potentially higher-returning stocks or stock funds – because you have more time to recover from any market slumps along the way.
• Index funds such as those based on the Standard & Poor’s 500 index are a good all-around pick for the stock portion of your portfolio. They’re a top recommendation from legendary investor Warren Buffett.
• As you age, however, your asset allocation should shift to more conservative investments – bonds or bond funds – to help protect your portfolio from the volatility of stocks.
• Use any tools offered by your 401(k) provider. Many 401(k) plans offer tools (online calculators, worksheets) for determining risk tolerance and suitable investment options.
• If you’re not comfortable selecting funds or building an investment portfolio on your own, the best tool may be a competent financial advisor. Select an advisor who can design a long-term plan for you and help you stick to it – here’s how to find one.
• Time is your most important ally when investing for retirement. It’s less important to find the very best investment than it is to find a good investment and then buy and hold it for years, if not decades.

Bankrate’s 401(K) calculator can help you estimate your savings over time.

Why should you invest in a 401(k)?

A 401(k) is an excellent investment option, and everyone should consider opening an account if they’re able to. Not all employers offer a 401(k) retirement plan, but if yours does, it’s a smart move to participate in one for the following reasons:

Still, some investors are worried about investing in stocks because of their riskiness.

“All investments come with risk, but the fear of losing money should not inhibit someone from utilizing a 401(k),” Golladay says.

While markets go up and go down, history has shown that over the long run, they move up. As measured by the Standard & Poor’s 500 index, over time stocks returned around 10 percent annually. The S&P 500 comprises hundreds of America’s largest publicly traded companies.

That’s why investors, especially the risk-averse, should take a long-term approach to their retirement investments.

“In times of market volatility or uncertainty, it’s important to remember that panic isn’t a strategy, especially with an investment as long-term in nature as a 401(k),” Golladay says.

What is a 401(k) loan?

If you need cash for an emergency or to pay down debt, your 401(k) plan may allow you to take out a loan and borrow up to 50 percent of your vested balance, but not more than $50,000.

In most cases, you have to repay the money with interest within 5 years. While the interest payments go into your account – which means you are paying yourself back rather than giving your money to a bank – there are significant downsides.

When you make a 401(k) withdrawal, that money is no longer invested in the market, and therefore, you could miss out on gains if asset prices continue to rise. Also, the original contributions to the account were made with pre-tax dollars, but the loan payments will be made with after-tax dollars. So, you’re losing a key tax benefit here.

If you leave your employer, you’ll also have to repay your loan faster, generally when taxes are due for the current tax year.

Try to avoid taking a 401(k) loan if at all possible, though it may be better than taking an early withdrawal.

401(k) FAQs

Traditional 401(k) vs. Roth 401(k)

The 401(k) has two varieties: the traditional 401(k) and the Roth 401(k).

• Traditional 401(k): Employee contributions are made with pretax dollars, lowering your taxable income. Your contributions grow tax-deferred until withdrawn, meaning all of your money is working for you in the market. Any 401(k) withdrawal that occurs before age 59 1/2, however, may be subject to an additional tax and a 10 percent penalty.
• Roth 401(k): Contributions are made with after-tax dollars, meaning you don’t get a tax benefit today. Your contributions grow tax-free until withdrawn in retirement, at age 59 1/2 and above, and then you’ll be able to avoid tax entirely on the distributions.Your 401(k) contributions are automatically deducted from your paycheck and may be matched by your employer, making it easy to automate saving for retirement and invest regularly.

For 2024, the maximum contribution you can make to a 401(k) plan is $23,000, according to the IRS. Those age 50 and older can make an additional “catch-up” contribution up to $7,500. Importantly, any matching funds from your employer don’t count toward this limit. So if you receive an employer match, you can actually exceed this limit each year with no concern.

Employees need to consider several things as they get started with a 401(k) – the details of your employer’s plan, how much you should contribute, what investments to select and what happens to your plan when you leave your job.

What happens to your 401(k) when you switch jobs?

Fortunately, a 401(k) offers portability, so you don’t need to be stuck in a former plan if you don’t like it. Workers have a few options for dealing with their old 401(k) after leaving a company:

• Roll it over into an IRA.
• Keep the assets in the former employer’s plan, if permitted.
• Roll it over into a new employer’s plan, if permitted.You may also have the option of taking a cash distribution, or lump sum, but you’ll probably get hit with penalties and taxes if you’re not at least of retirement age.

Whichever path you choose, it’s important to understand the benefits and limitations of each option according to your unique financial situation, Golladay says.

Taking an early distribution could be disastrous for your retirement, and more than half of Americans say they are behind in saving for retirement, according to a Bankrate survey.

Can you lose money in a 401(k)?

Whether you make money or lose money in a 401(k) depends on your investments. Some investments such as U.S. government bonds may have explicit promises to be repaid, or you may have an investment in cash, which will not decline in value, though it will lose purchasing power over time due to inflation.

Other market-based investments, including government bonds, are subject to fluctuations in value, so you may not receive back what you put into the investment. For example, while holders of government bonds will receive their principal back at maturity, the bonds may fluctuate a lot in the interim. So if you have to sell the bond before it matures, you may not receive the price you paid for it. At maturity you will receive full value, however.

Assets such as stocks can fluctuate a lot more in the short term than bonds. That’s why financial advisors recommend having a longer time horizon for stocks. You’ll need to ride out the market’s ups and downs in order to potentially achieve stocks’ more attractive long-term returns.

However, regardless of your investment choices, you’ll still pay fees for any funds that you’re invested in. Your long-term performance depends on those fees, so it’s important to minimize them where you can. And don’t think that a higher-priced fund is necessarily better than a low-cost fund. Often higher-priced funds have lower long-term returns than the lower-fee funds.

Is it worth having a 401(k) plan?

A 401(k) plan is one of the most attractive ways to save for retirement, if you use it how it was intended. You’ll enjoy tax-deferred or tax-free growth on your investment, and you can enjoy further tax breaks on your contributions if you’re using a traditional 401(k) or tax-free withdrawals if you’re using a Roth 401(k). That means you can be invested in some of the top-performing assets such as stock funds and enjoy attractive long-term returns while minimizing taxes.

On top of all that, you may be able to receive free “match” money from your employer just for contributing to your own retirement. That’s easy money that you can’t afford to turn down.

So it’s little wonder that millions of Americans have saved trillions of dollars in their 401(k) plans.