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Morningstar

401(k)

Sachin Nagarajan

What is a 401(k)?

A 401(k) is a retirement savings plan offered by employers and funded by an employee with pretax contributions.

  • A 401(k) is a retirement savings plan offered by employers and funded by employees with pretax contributions.
  • 401(k) contributions and investment growth aren’t taxed, but withdrawals are taxed after a specific age, 55 or 59 ½.
  • The IRS limits how much individuals can contribute to a 401(k) every year. In 2023, the limit is $22,500.
  • Some companies may offer a Roth 401(k) option, employee match, or automatic enrollment into traditional 401(k)s.

The 401(k) was created by Congress in 1981 and received its name for the section to which it belongs in the Internal Revenue Code, section 401(k). It allows employees to contribute pretax income to a retirement savings account that can invest in a variety of investments like stocks, bonds, or mutual funds. One of the 401(k)’s many advantages is that contributions and investment growth aren’t taxed. Instead, 401(k) money is taxed at ordinary income tax rates when it is withdrawn in retirement. Any withdrawals before the designated retirement age (59 1/2 in most cases but 55 in some) incur a 10% penalty and are subject to ordinary income tax rates.

Because these contributions aren’t taxed, the Internal Revenue Service (IRS) limits how much an individual can contribute annually. The current limit, in 2023, is $22,500 for anyone under the age of 50 and $30,000 for anyone older. Another benefit is that many companies offer an employee match, which involves a company contributing a certain percentage of an individual’s contribution. For example, a company could match 100% of an employee’s contributions up to 7% of their pretax income.

Companies have many choices among plan administrators, 401(k) plan options, and investment lineups. Some may offer a Roth 401(k) option, which allows employees to pay taxes on contributions, but investments grow tax-free and withdrawals after a certain age are also tax-free. Some companies also offer nonelective, automatic contributions. This means the organizations automatically enroll employees into a traditional 401(k) and invest a certain percentage of their pretax income.