How a 401k Retirement Plan Works

A generation ago, the 401(k) retirement plan was unusual.  Retirement planning consisted more frequently of company sponsored retirement plans, supplemented by social security and traditional IRAs.  The growth of 401(k) plans partly reflect a growing desire on the part of employees to take more control of their retirement savings, but it also represents a response by employers to the desire to get the liability of pension plans off their books.  The result has been a shift from defined-benefit plans to defined-contribution plans.  The following is a short summary of how a 401(k) retirement plan works.

Internal Revenue Code section 401(k) allows an employer to establish plans that are: defined contribution plans, which take pre-tax money from an employee’s paycheck, where the employer may match the contribution in whole or in part, and the investments grow tax-deferred until retirement.  Let’s look at each of these aspects of the 401(k) in turn.

The 401(k) is a defined contribution plan.  The accounts are characterized by the amount of money put in, with no guarantee of how that contribution will grow over time.  This makes them different from many company pensions or social security, which are termed defined-benefit plans.  A defined contribution plan starts with what the employee put in, and allows market forces to dictate the ending value of the account.

Contributions to a 401(k) are made on a pre-tax basis.  For the purposes of income tax in the year of the contribution, it is as if the employee never made that income.  It is removed from the paycheck before income tax withholding is computed.  This gives an immediate return on the contribution in the amount of the employee’s marginal tax rate.  If an employee is taxed at the 25% rate, then a $1000 contribution to the 401(k) results in $250 less due in taxes at the end of the year.

A significant benefit to the 401(k) over almost any other retirement plan is the option for employers to match contributions, either in whole or in part.  Those employers who take part in this option tend to cap their matching, and might only go dollar for dollar up to a certain point.  But this is free money for the retirement account of the employer.

Finally, a 401(k) allows for tax deferred growth of investments until retirement.  This allows for a higher effective rate of return, because income taxes or capital gains taxes are not assessed in the intervening years.  Assuming the investments grow at 10% per year, and that the employee is in the 25% marginal tax rate, tax deferred growth means the difference between 10% returns and 7.5% returns.

The benefit of a 401(k) contribution compared to a normal savings plan can be demonstrated by an example.  If an employee contributes $4,000, is in the 25% tax bracket, and the company matches the contribution one for one, in the year that the contribution is made the employee sees $3,000 less in a paycheck, but ends the year with $8,000 in the account.  In exchange for giving up $3,000 out of pocket, the employee gains an additional $5,000.  In the following year, the investment returns 10%.  The $8,000 grows to $8,800, but the employee pays no income tax in that year on the growth.  By contrast, if the employee had put the money in a regular investment account, the amount deposited would be $3,000 (because of the 25% tax rate) and over the first year the amount would grow to $3,300.  But the $300 would be taxed at 25% also, so $75 would go to the IRS, leaving only $3,225.

There is one drawback to the 401(k), and that is that yearly contributions are limited.  In 2011 the amounts are set at $16,500 for employees under the age of 50 and $22,000 for employers age 50 and older.  The amounts increase periodically to account for inflation.

The 401(k) combines three of the most powerful retirement tools available: pre-tax earnings in the year of contribution, tax-deferred growth until retirement, and for some employees, employer matching contributions.  If the plan is available, participating should be one of the employee’s highest financial priorities.