What is a 401(k) Plan?

A 401(k) is a tax-advantaged investment account commonly offered by employers as a retirement savings benefit to new and existing employees.

As you begin planning for retirement, it’s wise to factor your employer’s 401(k) offering into your broader strategy.

However, it may be challenging to understand all the forms, guidelines and paperwork surrounding 401(k)s.

In this article, we’ll provide a basic rundown of what a 401(k) plan is and how it fits into your broader retirement strategy.

Note, however, that the sections below simply provide general information about these account types.

If you want to opt in to your employer’s 401(k) plan—or are about to make any other decision about your retirement savings strategy—it’s smart to run your plan by an experienced financial advisor first to make sure your strategy is a smart choice for your overall financial situation.

What’s a 401(k) plan?

A 401(k) is a retirement savings account that lets you invest your money and minimizes the taxes you’ll have to pay on your contributions.

Most 401(k)s are employer-sponsored retirement plans. This means that your employer will set up and manage the account—usually through a third-party service.

If you opt in to your employer’s 401(k) plan, they’ll withdraw your chosen contribution directly from your paycheck and deposit it into your 401(k) account.

In most cases, your employer will also match a portion of your contribution to your 401(k).

Traditional 401(k) Accounts vs. Roth 401(k) Accounts

As with IRAs, you can set up your 401(k) plan as either a traditional or Roth account.

In a traditional 401(k), you can contribute money to the account pretax. This means any contributions you make to your 401(k) won’t be taxed upfront. Once you reach retirement age and start making withdrawals, the IRS will tax any money you take out as a source of income.

In a Roth 401(k), you can use post-tax money to fund the account. This means that the IRS will tax you upfront for any contributions you make in the year you make them. Once you reach retirement age, you can withdraw the money without incurring any taxes.

When deciding between these two account types, the most important thing to keep in mind is whether you believe your income today will be more or less than your income in retirement.

To be more specific, if you believe your income will be higher in retirement, you’ll generally want to be taxed on that income today so you can take advantage of your lower tax bracket. This means investing your money in a Roth 401(k) plan.

If you believe your income will be lower in retirement (as is usually the case), you’ll generally want to be taxed on the money once you retire since you’ll be in a lower tax bracket. This means investing your money into a traditional 401(k) plan.

Traditional vs. Roth 401(k) Example

Imagine for a moment that you’re 25 years old and currently make $70,000. You’ve done the math and know that in retirement you’ll need to withdraw around $20,000 per year from your investment accounts to pay for your expenses.

In this case, you want to start contributing money to your employer’s 401(k) to help fund your future retirement.

When you pay your taxes, the IRS will calculate how much you owe based on where you fall into predefined tax brackets.

Using the numbers for 2023, the IRS would tax your $70,000 in income based on the following brackets (using round numbers for simplicity):

• The IRS will tax the first $10,000 at 10%—you will owe $1,000 on this amount.
• The IRS will tax the next $30,000 at 12%—you will owe $3,600 on this amount.
• The IRS will tax the last $30,000 at 22%—you will owe $6,600 on this amount.

Similarly, if taxes remain at their current levels into your old age, the IRS will tax your annual retirement withdrawals of $20,000 in the 10% and 12% brackets for a total tax bill of $2,200.

As you can see, the higher your income is in a given year, the more the government will tax you in these higher income brackets. It’s important for you to minimize your taxable income wherever possible so you can keep the majority of it in the lower brackets.

If you choose to contribute $20,000 to a traditional 401(k) account per year, your annual taxable income would only be $50,000, since the $20,000 contribution is applied pretax.

This means that the IRS will tax a higher percentage of your income in the lower bracket, significantly decreasing the taxes you’ll pay by deferring these taxes to your retirement, where they’ll (likely) be taxed at a lower rate.

To continue with the example above, the difference you’ll pay in taxes by investing in a Roth 401(k) over a traditional 401(k) can be significant:

• Taxes on an income of $70,000 earned today and $0 withdrawn in retirement (Roth 401(k)): $11,200
• Taxes on an income of $50,000 today and $20,000 withdrawn in retirement (traditional 401(k)): $9,000

Specifically, in this situation (ignoring all outside factors and assuming the tax code stays the same for the next 40 years) investing $20,000 every year in a traditional 401(k) would save you $2,200 per year over investing in a Roth account.

Note, however, that no one can predict the future.

Each account type has different advantages and risks over the other, and figuring out which one will work better for you can be complicated.

For this reason, it’s important for you to go over your exact situation with a financial advisor before you choose a traditional 401(k) plan or a Roth 401(k) plan.

Often, the answer will come down to the specifics of your financial situation, meaning that neither plan is inherently better or more advantageous than the other for the average American.

Understanding Employer Matching

Often the most important perk of investing in a 401(k) plan (outside of the higher contribution limit compared to an IRA) is that your employer will match your contributions up to a certain amount.

In most cases, your employer will use one of several different formulas to calculate how much of your 401(k) contribution they’ll match:

• Basic Match — Your company will match the first 3% of your paycheck you choose to contribute, plus a 50% match on the next 2–3%.
• Enhanced Match — A flat 100% match on the first 4–6% of your paycheck you choose to contribute.
• Nonelective Contribution — For nonelective contributions, your employer will deposit a set amount into your account each paycheck, regardless of whether you choose to contribute or not.

These three methods are the most common employer matching strategies for 401(k)s, but they’re far from an exhaustive list of all the different formulas employers may use to contribute to your 401(k) plan—so be sure to find out the specifics of your employer’s plan directly from them.

However, most average out to around a 3–4% match or nonelective contribution each paycheck.

This means that the moment the money hits your 401(k) account, you can think of it as an automatic 100% return on your investment (if matched) or just free money for your retirement (if contributed).

Finally, specific to the matched contribution option, note that contributing money to your 401(k) above the amount needed to receive your employer’s full match is optional. It’s generally recommended that you contribute as much as you need to receive your employer’s full match. Then, you can choose where to put the rest of your retirement savings based on the funds available (and fees included) in each account type—401(k) and beyond.

Frequently asked 401(k) questions

Figuring out the rules and restrictions surrounding 401(k) plans can be complicated, and you may have further questions about what’s best for you.

We’ll answer a few general questions below, but please reach out to an experienced financial advisor if you have any specific questions about your retirement investment strategy or 401(k) accounts.

Why should I invest in a 401(k)?

There are several reasons to invest in a 401(k) plan over an IRA or other investment vehicle:

• By investing in your employer’s 401(k), you can take advantage of their contribution match to get an immediate and substantial return on your investment.
• When compared to IRAs, 401(k)s have a much higher contribution limit (currently $22,500 per year and increasing), meaning you can save more of your money in a tax-advantaged account.
• Most 401(k) plans offer flexibility in the account type (traditional or Roth) as well as the investments you can choose from. While 401(k)s rarely have as much freedom as IRAs, they’re still flexible enough to give you the ability to manage your account’s growth in a way that fits your needs.

Due to these benefits, it’s generally wise to contribute enough money to your 401(k) plan to at minimum take advantage of your employer’s full match.

Then, once you max out your employer match, you can decide whether to contribute more money to your 401(k), contribute it to a separate IRA or choose a different retirement strategy.

What happens to my 401(k) if I quit my job?

While the nuances can get a little complex depending on the specifics of your employer match (such as if the money vests after a certain period), you’ll retain ownership of most of the funds in the account after quitting your job.

In this scenario, you can choose from one of several options:

• Leave it where it is — Some employers allow you to leave the 401(k) account as-is in the event you quit your job. You’ll still have access to the funds, and they’ll continue to grow in the account, but your employer won’t match any contributions you might make.
• Roll it over to your new employer’s 401(k) — If your new employer offers a 401(k) plan, you also have the option of rolling your old 401(k) account over into your new one. Basically, this means moving your funds from your old account into the new one without incurring any tax penalties or other consequences.
• Roll it over to an IRA — Similarly, you also have the option to roll the 401(k) account over into an IRA in your name. This means that you’ll transfer the funds from your old 401(k) into an IRA you have ownership over. From this point, your funds will follow all the rules surrounding IRAs, and you won’t receive any employer matching.
• Take distributions or cash it out — Finally, you could also choose to leave the money where it is but start withdrawing money from the account. If you’re nearing retirement age, you may want to consider taking regular distributions to pay for your retirement expenses. Similarly, you could also choose to cash the entire account out at once. However, this strategy isn’t recommended because it would mean paying taxes on the account’s full amount (as well as any penalties that may apply for taking the money out early).

Can I lose money in my 401(k)?

Yes. You can lose money in your 401(k) account if you choose to invest in assets that can decrease in value, such as stocks, bonds, index funds and other similar financial vehicles.

Investing in a 401(k) strategy means saving money until retirement. Swings in the broader market only matter in two scenarios: if you choose to sell when prices are low or if you choose to withdraw the money while the market is in a downturn.

Consider a 401(k) as a part of your broader retirement plan

If your employer offers a 401(k) retirement plan with matching or nonelective contributions, it’s generally a good idea to take advantage of the plan to get a head start on your retirement savings.

Saving for retirement can be difficult, but the benefits and simplicity offered by 401(k) plans can make the entire process easier.

Note, however, that there are no certainties in investing, and you should always customize your retirement strategy based on the specifics of your unique situation.

Begin your retirement planning journey by speaking with a financial advisor who can answer all your questions. An experienced professional who can review and understand your financials can give you the advice and guidance you need to make informed decisions about your retirement plans.

If you have any questions about retirement planning or how your employer’s 401(k) plan fits into your overall retirement strategy, give us a call at 800-236-8866, schedule an appointment or stop in at any of our Associated Bank locations.

We’d be happy to help you find a path toward meeting your financial goals.