What is a 401K retirement plan, how does it work and how to open one?

Americans have several options they can take advantage of when saving for retirement. One such is 401(k) plan through their employer which depending on the type could come with upfront tax benefits or tax-free distributions when you retire.

The basics of 401(k) plans

Named after a section of the US Internal Revenue Code, a 401(k) is a retirement savings and investing plan offered by many American employers. Contributions are automatically taken out of a worker’s paycheck and invested in funds selected by the employee from a list given to them by the plan administrator.

With traditional 401(k) plans, the funds are withdrawn from the pre-tax amount of a paycheck and the employee gets a tax break upfront. However, they will be liable to pay income taxes on them when they withdraw down the road. A Roth 401(k) plan works the other way around, you pay in with after-tax money and then in retirement you don’t pay tax on qualified withdraws.

An added benefit is that employers often offer to match your contributions if you put at least a certain amount into your 401(k) plan. The IRS raised the maximum amount an employee can contribute to his or her account in November, increasing it to $20,500 in 2022, up from $19,500. For savers 50 and older the catch-up deposit amount remained the same, capped at $6,500.

For 2023 the IRS will increase the contribution limit by $2,000 to $22,500. Workers who are saving for retirement with 401(k), 403(b), most 457 plans, and the Thrift Savings Plan can contribute up to $22,500 to those plans in 2023.

For those saving in a traditional or Roth IRA the 2023 limit on contributions rises to $$6,500 next year, a $500 increase.

If you need to withdraw money from your 401(k) plan before you turn 59½ you could incur a hefty penalty. There are some cases where you can draw down on your 401(k)-retirement nest egg after you’ve turned 55 without being punished such as an additional 10 percent penalty on top of taxes that would be levied.

How can I open a 401(k)?

Some employers will automatically enrol employees in a retirement plan. If not then notify your employer to sign up. Employers will usually match retirement contributions, enhancing the savings you are making for future life.

With regular 401(k)s deducting from your paycheck, there are tax breaks with a smaller income. However, taxes may still need to be paid when withdrawals are made in retirement. Roth 401(k)s invest money after it has been taxed though withdrawals are free. Both plans can be invested in at the same time.