How a 401k Retirement Plan Works

A 401(k) retirement plan is a tax-deferred retirement savings vehicle which is governed under subsection 401(k) of the Internal Revenue Code. It allows you to contribute to the plan now and pay tax only when you withdraw from the plan after retirement, when your income and tax bracket will probably be lower.

Although 401(k) plans can be administered by the owner of the plan or by a selected trustee, most 401(k) plans are administered by the employer. Employer-administered 401(k) plans are usually divided into 2 categories: defined benefit and defined contribution.

In a defined benefit 401(k) plan, an employer pledges to pay a fixed amount every month to retired employees. The amount of the payment usually depends on the retiree’s age, number of years served at the company, and final average salary at the company. In lieu of monthly payments, a defined benefit plan may also provide a lump sum to the retiring employee, which can be rolled over into a different retirement vehicle. There is little or no flexibility or inflation protection built into these kinds of plans.

The primary advantage of a defined benefit 401(k) retirement plan is that the employee can be certain what his retirement earnings will be, provided the company remains healthy. However, he has no power to influence the method of investment.

In a defined contribution 401(k) plan, the employee sets aside a fixed amount of his salary per month toward his retirement savings, up to the maximum 401(k) contribution each year. Although the employer administers the plan, the employee may usually choose from a number of different investment options. Upon retiring, the employee receives the proceeds of his 401(k) retirement plan in either an annuity or a lump sum, which can be rolled over into a different retirement vehicle.

The primary advantage of a defined contribution 401(k) retirement is the employee’s ability to control the contribution amount and, to some extent, the manner of investment. However, the employee has no guarantee of a minimum retirement outcome.

All withdrawals from 401(k) plans are subject to income tax, unless they follow strict rollover rules. It is very difficult to make early withdrawals from employer-administered 401(k) plans.

One alternative to the standard 401(k) plan is the Roth 401(k) retirement plan. Unlike standard 401(k) plans, which are tax-deferred, qualified contributions to Roth 401(k) retirement plans are after-tax dollars. This means that the interest proceeds from a Roth 401(k) are tax-free, providing the rules of qualifying contribution and withdrawal are followed. Roth 401(k) qualifying contributions may only be made to designated Roth accounts.