401(k) plans (also just called 401k) are types of retirement plans that an employer sponsors which allows employees to defer taxes. 401k plans originate from the Internal Revenue Code (IRC) section 401(k) which allows contributions to these plans to be tax-free until the person begins withdrawing the income during retirement. If their employer offers the plan, an employee can contribute up to a limit which changes each year along with contributions from the employer. Often, employers contribute a certain amount to a 401k plan based on the amount the employee contributes. For example, XYZ Co. may contribute 50 cents for every dollar an employee contributes to their 401k up to $10,000 every year. The employee usually has limited investment options to choose from for their 401k account depending on the employer.
In 2022, an employee can contribute $20,500 before tax is applied. The employee and the employer can make further contributions up to $61,000, but these further contributions will be taxed in the year contributed. People aged 50 and over can contribute an additional $6,500 before tax to their 401k since they are closer to retirement.
A person may begin taking money from their 401k when they reach 59 ½ years of age or meet certain exceptions such as for disability. If a person withdraws money from their 401k before they meet these requirements, the person must pay a 10% penalty tax on top of the other taxes on withdrawals. Once someone reaches the age of 72, they must begin making a specific amount of withdrawals from their 401k unless they continue to work.
401k plans are different from Roth 401k. Roth 401k tax all contributions before entering the account, but withdrawals from the account upon retirement receive no taxes at all. Roth 401k can be beneficial for individuals who expect to receive less taxes now than in the future. A person may contribute to both 401k and Roth 401k, but their contributions to both cannot exceed the contribution limits.
Compare 401k with individual retirement accounts (IRA) here.
[Last updated in December of 2021 by the Wex Definitions Team]