What Is a 401(k)? Definition, Benefits, and Why It’s Important

By Upstart Content Team | Updated November 23, 2022
reading time 6 min read
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Key takeaways: 

  • A 401(k) is a type of employer-sponsored retirement savings and investment plan.
  • 401(k)s offer several advantages to enrollees, including tax deductions and deferments. 
  • Choosing a tax-deferred retirement plan may make it easier to save for retirement by reducing the amount of income taxes you have to pay now.

Whether you’re beginning your career or approaching retirement, you’ve likely heard of a 401(k). These retirement plans have become a key fixture of employee benefits, thanks to their tax advantages and long-established history of growth.

However, it’s important to know exactly what a 401(k) plan is, as well as the alternatives that are available to you as you prepare for retirement. That way, you can make the most of your salary and enjoy the confidence of a growing nest egg. Learn more in this guide to 401(k) plans.

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

A 401(k) is a type of retirement savings and investment plan offered by some employers. 401(k) plans were named after the section of the IRS tax code that established them—namely, subsection 401(k).

Generally, you agree to invest a portion of your paycheck into your 401(k) after signing up. Your company may then match some or all of your contributions. You can typically choose from one of several investment options, including mutual funds, stocks, and bonds. 

You may also be able to choose between two types of 401(k) plans: traditional and Roth. We’ll get into the types of 401(k)s shortly. In the meantime, let’s take a look at the ins and outs of 401(k) contributions.

What is the max contribution to a 401(k)?

As of 2022, you can contribute up to $20,500 to your 401(k) each year. If you’re over the age of 50, you may be eligible to make catch-up contributions, which allow you to invest more money in your account as you get closer to retirement. For instance, in 2022, those over 50 can contribute up to $27,000 into a 401(k).

What is a Roth 401(k)? Traditional 401(k)s vs. Roth 401(k)s

Traditional and Roth 401(k)s work in a relatively similar way. In fact, the main difference is how each account is taxed. 

With a traditional 401(k), your contributions are considered “pre-tax.” That means each contribution reduces your taxable income for that year. However, future withdrawals will be subject to income taxes.

Contrastingly, Roth 401(k) contributions are made with after-tax money. If you choose a Roth 401(k), your contributions won’t reduce your taxable income and you’ll have to pay income taxes on the money you invest each year. But, future withdrawals won’t be taxed.

What is a good 401(k) match?

The most common employer match is a dollar-for-dollar investment of up to 6% of your income. For a look at what that means, consider the following. 

Your employer offers a 401(k) plan with a matching contribution of up to 6%. Your salary is $50,000 annually. You decide to contribute 6% of your income to your 401(k), or $3,000 each year.

Your employer will also invest $3,000 into your retirement account each year. Employer contributions will increase as your salary increases. Your employer’s contribution will never be more than 6% of your salary, even if you increase your contributions.

How to start a 401(k) plan

Because 401(k)s are employer-sponsored retirement plans, the only way to start one is to sign up through an employer.

Many employers enroll new hires in their workplace plan automatically, though some have a waiting period before new employees can join the retirement plan. If your employer has a waiting period, create a reminder in your phone or calendar and enroll as soon as possible.

Once you’re enrolled, simply choose an account type (i.e., traditional vs. Roth), select your investment plan, and set up an automatic contribution. 

As a general rule, it’s a good idea to contribute up to your employer’s match at the very least, if possible. Doing so allows you to get the most out of your investments and grow your retirement fund faster.

What if my company doesn’t offer a 401(k)?

Unfortunately, some employers don’t offer 401(k)s. Similarly, you may not be eligible for one if you’re self-employed or work as an independent contractor.

If you’re not able to enroll in your employer’s plan, don’t worry. You can still save for retirement and get similar tax breaks from an individual retirement account (IRA). There are two main types of IRAs to choose from: traditional and Roth. Let’s take a closer look at each and how they compare to a 401(k).

What is the difference between an IRA and a 401(k)?

401(k) plans and IRAs are both types of retirement savings and investment accounts. However, they have a few significant differences. 

Consider the following for an at-a-glance look at the differences between a 401(k) and an IRA.

401(k) Traditional IRA Roth IRA
Employer-Sponsored Yes No; open to anyone who earns an income No; open to anyone who earns an income
Contribution Limit in 2022 $20,500 (or $27,000 for those 50 and older) $6,000 ($7,000 for those 50 or older) $6,000 ($7,000 for those 50 or older)
Catch-Up Contributions Yes Yes Yes
Pre-Tax Contributions Yes Yes No
Tax-Exempt Distributions No No Yes
Income Restrictions No No Yes

Source: IRS Retirement Plans

Can you have a 401(k) and an IRA?

Torn between the tax benefits of a 401(k) and the flexibility of an IRA? We’ve got good news: You can enroll in both a 401(k) plan and an IRA. You may contribute money to each, up to the annual maximum, and take even more control over your retirement plans.

Still, it’s important to choose the right plan. As shown above, Roth IRAs have income limits that may make them off-limits to high-earners (i.e., single filers who make more than $144,000 and married filers who earn more than $214,000). With that in mind, do your research or consult with a financial advisor to determine the best retirement plan for your needs.

Benefits of a 401(k)

A 401(k) can be an incredibly useful tool for retirement planning. However, it can be tempting to delay contributions, especially if you’re young, working to save money while paying off debt, or planning for major life events, like a wedding or starting a family.

With that said, opening a 401(k) as quickly as possible allows you to make the most of your employer’s plan and kickstart your retirement savings from a young age. 

Still not sure if a 401(k) is right for you? Consider the following advantages of an employer-sponsored retirement plan.

1. Your employer may match your contributions

One of the main perks of a 401(k) is that your employer may match some or all of your contributions. Matches may vary, with some employers offering dollar-for-dollar or 50-cents-on-the-dollar matching up to a certain percentage.

Regardless, if your employer offers a matching plan, it’s a good idea to set up your 401(k) now. Only you can determine how much you’re able to contribute. If possible, invest enough to take advantage of your company’s maximum contribution.

2. Your contributions may be pre-tax

Contributions to a traditional 401(k) are considered pre-tax. This means that every dollar invested in your retirement savings plan is a dollar you don’t have to pay income taxes on—at least until you begin making withdrawals in the future.

For instance, if you have a $50,000 salary and invest 6%—or $3,000—you only have to pay income taxes on the remaining $47,000.

3. Funds in your 401(k) won’t be taxed until you withdraw them

Another benefit of a traditional 401(k)? Your money won’t be subject to taxes as long as it’s in your account.

Essentially, a 401(k) creates a tax-free umbrella. If your money remains in the account, all of it (including interest, dividends, and investment gains) is considered tax-deferred. You will have to pay income taxes on the money you withdraw in the future. However, it gives your nest egg plenty of time to grow in the meantime.

4. You can take your 401(k) with you

Finally, 401(k)s follow you wherever you go in your career. If you change jobs, you can roll over your existing 401(k) account into a new one. Ask your new employer about the process or talk with a professional to determine if converting your 401(k) into an IRA is the best move for your financial future.

Wondering if a 401(k) plan is right for you?

Enrolling in a 401(k) is an important first step on the path to retirement planning. Still, it’s essential to consider your options and determine the best type of retirement savings and investment account for your needs. 

For instance, you may prefer the immediate tax deductions that come with a traditional 401(k). On the other hand, you could opt against the deferrals and reduce your tax liability in the future. 

No matter what you decide, work with your employer or a trusted financial advisor to save for retirement as soon as possible. That way, you’ll be well on your way to financial freedom in your golden years.

This content is general in nature and is provided for informational purposes only. Upstart is not a financial advisor and does not offer financial planning services. This content may contain references to products and services offered through Upstart’s credit marketplace.

About the Author

Upstart Content Team

The Upstart Content Team shares industry insights, practical tips, and borrower success stories to help people better understand the important “money moments” of their lives.

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