Question 1

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

Accepted Answer

A 401(k) plan is an employer-sponsored retirement savings plan that allows an employee to contribute a portion of his or her paycheck into a tax-advantaged investment account. The employee (or plan participant) typically chooses from a range of investment options within the 401(k) plan. These options, which often include mutual funds, are chosen by the plan sponsor—usually the employer. Approximately half of all assets in 401(k) plans are invested in mutual funds, which in turn are invested in stocks, bonds, and short-term investments.

Question 2

What are the benefits of investing in a 401(k) plan?

Accepted Answer

401(k) plans are one of the most popular and successful retirement saving tools. They offer several benefits:

Tax planning. A traditional 401(k) plan reduces an employee’s immediate taxable income because contributions are tax-deferred. Many participants anticipate being in a lower tax bracket in retirement compared to their peak earning years, which may result in lower tax rates on 401(k) plan withdrawals in retirement. However, some participants, such as young employees with many working years ahead of them, may anticipate being in a higher tax bracket at retirement. If the 401(k) plan offers Roth 401(k) plan accounts, these participants can choose to pay tax on their contributions up front and pay no tax upon withdrawal. The ability to set aside some of their income on a tax-deferred basis, and in some cases to determine how their own contributions are allocated between a traditional and Roth 401(k), is just one way that 401(k) plans allow plan participants flexibility in tax planning for retirement.

Tax-deferred growth. The money saved in a 401(k) plan grows and compounds more quickly because the total balance in the account isn’t taxed on a yearly basis.

Employer match. Many 401(k) plan participants can increase their savings by taking advantage of an employer match—an additional contribution made by the employer that depends on how much the employee contributes.

In addition to those benefits, 401(k) plans are especially well suited for today’s economy because they are portable, employees have full ownership of their vested contributions and investment returns, and the 401(k) industry is constantly innovating to ensure that it keeps up with an evolving job market and workforce.

Question 3

Is there a limit to how much an employee and employer can contribute to a 401(k) plan?

Accepted Answer

Yes. As of 2023, an employee can defer up to $22,500 total to a 401(k) plan per year as pretax or Roth contributions. If an employee is 50 years or older, the employee can defer up to $30,000 as pretax or Roth contributions by taking advantage of a $7,500 catch-up contribution.

Question 4

What is a catch-up contribution and who is eligible?

Accepted Answer

A catch-up contribution is an additional contribution to a 401(k) plan that can only be made by an employee who is at least 50 years old. Once an employee has hit the plan’s contribution limit or the annual deferral limit of $22,500 (in 2023), he or she may contribute up to $7,500 as a catch-up contribution. Most employers offer this option, and some companies also match a percentage of the catch-up contribution.

Question 5

Can participants borrow from their 401(k) plan accounts?

Accepted Answer

Yes, if the plan allows loans. The maximum amount an employee can borrow from a 401(k) plan generally is the lesser of 50 percent of the vested account balance or $50,000.
 
Every plan is different, but some companies only allow employees to take out loans for specific reasons. Some companies also might have specific conditions under which they will allow the loan. For example, an employer may have a minimum loan amount or a company might limit the total number of loans that can be outstanding at one time. If an employee is married, the employer may require the spouse’s consent to the loan.
 
An employee must pay back a loan in five years unless he or she uses the loan to buy a home (a principal residence). In that case, the company may extend the loan based on its own discretion. 401(k) loans are not subject to taxes or penalties (unless the employee defaults or the loan otherwise violates the loan rules), but an employee does have to pay interest on the loan. The plan administrator decides what the interest will be, which is usually based on the current prime rate of interest. Unlike many other types of loans, the employee pays the interest to his or her plan account—not to a bank or other lender.

Question 6

What happens to an employee’s loan if an employee leaves a job or is fired?

Accepted Answer

Depending on the plan’s policy, the employee may be required to pay back the loan right away or pay the remaining amount to an IRA or another plan as a rollover within 60 days.

Question 7

What happens if an employee can’t repay a 401(k) loan?

Accepted Answer

If an employee can’t repay a loan, the money will be treated as distributed, or withdrawn. The individual will be taxed on the outstanding balance and—unless the employee is at least 59½ years old—may face an early withdrawal penalty.

Question 8

What are the disadvantages to a 401(k) loan?

Accepted Answer

The main disadvantage of taking a loan is the possibility that the participant will be unable to pay it back. Another is that borrowing from a 401(k) may slow the growth of the account, because the money borrowed is not earning investment returns as it would in the plan.

Question 9

What are hardship withdrawals?

Accepted Answer

A hardship withdrawal is another way an employee can access money from a 401(k) plan. Plan policies vary, but usually employees cannot withdraw more than they have contributed. A worker must meet certain requirements to qualify for a hardship withdrawal:
 
The hardship must be due to an immediate and heavy financial need. Under IRS rules, a need that falls under one of the categories below is deemed to be immediate and heavy:

Buying a home or paying for certain home repairs

Paying for education expenses such as tuition and related fees, or for those of a spouse, child, or primary beneficiary

Preventing eviction from a primary residence

Paying tax-deductible medical expenses that are not reimbursed to an employee, spouse, child, or primary beneficiary

Paying for funeral expenses of a parent, spouse, child, or primary beneficiary

The amount must be necessary to satisfy the need (including that the employee can’t get the money from other sources).
 
Some plans require the employee to have exhausted all non-hardship distributions and other loans available from plans maintained by that employer.

Question 10

When can a participant begin drawing down a 401(k) plan?

Accepted Answer

A participant can start drawing down a 401(k) plan, penalty free, once he or she is 59½ years old. A participant generally must start withdrawing the required minimum distribution (RMD) from a 401(k) plan by April 1 of the first year after the later of the calendar year in which the participant retires or reaches age 72. For example, if a participant reaches 72 years of age in February 2021, he or she doesn’t have to withdraw the initial RMD until April 1, 2022. If that same participant retires in May 2021, the plan may allow him or her to postpone the RMD until April 1, 2022. These rules and requirements apply to a Roth 401(k) as well.

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FREQUENTLY ASKED QUESTIONS ABOUT 401(k) PLANS: