How Does a 401(k) Work?

You may know that a 401(k) allows you to make payroll-deducted contributions to a retirement account before taxes are taken out, but how does it work?

Employees can either become participants in a 401(k) by voluntary enrollment or by automatic enrollment with the ability to opt-out. Contributions go in before taxes are taken out, and this can reduce an individual’s taxable income or even income bracket for the year.

This is a nice benefit for employees, particularly if there are matching contributions made by the employer. Employers, and especially the highly paid upper management, need to have high participation and contribution rates from the non-highly paid individuals.

If a plan does not have enough participation, it can cease to be a qualified plan, or higher earners may not be able to contribute as much as they would like. There are a few tests that a plan must pass that analyze the amount of money going into the plan from Highly Compensated Employees (HCEs) and the average employees, to determine if a plan is top-heavy.

If a plan is top-heavy, the amount over what is allowed by the tests will be returned to the contributing individual. Safe Harbor plans give certain matching or flat contributions to all employees, and it allows the highly compensated to fund their accounts as much as they would like to, since there are no longer top-heavy tests.

The investments inside of a 401(k) grow without being taxed year-to-year like a retail investment account, but you cannot take out money from a 401(k) before age 59 ½ without getting hit with a 10% penalty tax from the IRS.

There are exemptions to this penalty, of course. In retirement, all withdrawals are taxed as income. Also, people must make withdrawals of a size that satisfy the Required Minimum Distribution amounts every year after they reach 70 ½ years old.

401(k) plans require a Custodian for the investment accounts, a Bookkeeper entity to keep records, oftentimes a Third Party Administrator (TPA) to coordinate between the employees, the employer, the custodian company, and the IRS.

Many plans are packaged in ways that allow one broker-dealer company to satisfy these roles. The employer bears a lot of responsibility as the plan sponsor and fiduciary with regard to ERISA laws.