This post covers everything you need to know about 401(k) plans, ranging from the benefits of participation to your options when changing jobs. As a bonus, we’ve included a section on steps to take if you’re uncomfortable with large swings in the value of your 401(k) investments. Let’s dive in.

Types of 401k accounts

Traditional 401(k)
A traditional 401(k) is an employer-sponsored retirement account that comprises various investments—typically stocks, bonds, and mutual funds—that the employee can choose from themselves or with the help of a financial advisor. Employees who wish to participate can invest a percentage of their pretax income (with the money automatically coming out of their paychecks) to fund their account. As an added benefit, most employers match employee contributions (up to a predefined percentage): which is essentially “free money” for the participating employee!

Roth 401(k)
Some employers may also offer a Roth 401(k) plan, which works like a traditional 401(k) but is funded with after-tax dollars. For this reason, any Roth 401(k) withdrawals made during retirement are tax-free.

Owning a Roth 401(k) is sometimes beneficial as it’s difficult to predict which specific tax bracket you'll fall into years from now. With this in mind, participating in both types of 401(k) accounts can provide some level of tax diversification: meaning some of your assets are fully taxed upon withdrawal while others are not.

After-tax 401(k) contribution
Some employers also offer a third option: an after-tax 401(k) contribution account, which is a hybrid of both a Roth and traditional 401(k). These accounts feature after-tax contributions, but growth is tax-deferred: meaning you’ll only pay taxes on the amount you've earned whenever you withdraw funds. One of the most appealing features of these types of accounts is that the IRS allows you to contribute significantly more than you can to a standard 401(k).

As employer-sponsored Roth 401(k) and after-tax plans are less common overall, we’ll zero in on traditional 401(k) plans unless otherwise noted throughout the remainder of this article.

401(k) enrollment

While existing 401(k) plans are grandfathered in, most new employer plans automatically enroll participants: meaning anyone not interested in participating would need to proactively opt out. Automatic enrollment also includes a default contribution rate of at least 3% of your salary, which increases by 1% annually until it reaches at least 10%.

401(k) contributions

The IRS sets rules regarding how much you can contribute to 401(k) accounts on an annual basis, a number that generally increases yearly. For 2023, anyone under the age of 50 can contribute up to a maximum of $22,500 per year while their older counterparts can tack on an additional $7,500 (or less) to this number.

If you earn more than $145,000 from an employer this year and contribute to an employer-sponsored plan, such as a 401(k), 4013(b) or 457(b), catch-up contributions must be made to a Roth version of your respective retirement plan beginning in 2024 (assuming Congress doesn’t approve a delay), meaning you’ll pay taxes on your catch-up money up front, rather contribute pre-tax money, like you can now. However, you won’t have to pay taxes on the money or its earnings when you withdraw later in life. If your employer doesn’t offer a Roth version of your plan, then you can’t make any type of catch-up contribution to that plan.

Starting in 2025, employees between the ages of 60 and 63 will receive a “special” catch-up contribution limit for most 401(k)s and other employer-sponsored plans. More specifically, this equates to the greater of $10,000 or 150% of the standard catch-up contribution limit for 2025. Beginning in 2026, this amount will be adjusted for inflation on a yearly basis.

401(k) benefits

Corresponding tax benefits are the most significant advantage of 401(k) ownership.

First and foremost, contributions are tax-deferred as the account is funded with pretax dollars: meaning you won’t pay taxes on money in your account until you make a withdrawal.

Next, because contributions are made with pretax dollars, they lower your taxable income. For example, if you earn $100,000 a year and contribute $15,000 annually to your 401(k), only $85,000 of your earnings are subject to tax. As a result, your 401(k) contributions could ultimately drop you into a lower tax bracket.

Another 401(k) benefit is tax-free growth; any 401(k) balance gains will grow tax-free, provided you don’t withdraw money from the account before hitting the minimum age requirement (more on that later).

A final benefit is that your 401(k) is protected by ERISA (the Employee Retirement Income Security Act of 1974), protecting your account from creditors.

401(k) disadvantages

As with any retirement account, some drawbacks do exist with respect to 401(k) plan investments: including account fees, limited investment options, and early withdrawal fees.

401(k) fees
401(k) plan providers do charge fees that typically range from 0.5% to 2% of total plan assets and often fall into three categories: administrative, investment, and individual service fees.

Often the most expensive, investment fees cover investment management costs and are deducted directly from your investment returns—so make sure to pay close attention to your statements.

Administrative costs, meanwhile, cover plan maintenance expenses that can include account access and statements as well as customer service fees. While employers sometimes cover these, they are otherwise paid by plan participants themselves. As with investment fees, administrative fees are also automatically deducted from your plan.

Keep in mind that service fees are specific to each employee and charged for specific plan features/actions, such as taking out a loan.

Early withdrawal fees
Although some exceptions do exist (which we’ll get into shortly), anyone looking to make a withdrawal before the age of 59½ is subject to a 10% early withdrawal penalty from the IRS and also required to pay taxes on the withdrawal—assuming your employer even allows this.

Upon turning 59½ years old, however, you can withdraw money from your 401(k) without paying an early withdrawal penalty: though the amount is considered income and consequently subject to taxes.

Limited investment options
Compared to other retirement accounts such as an IRA or taxable brokerage account, your 401(k) may have fewer investment options. Nevertheless, some participants may view a limited investment menu as beneficial because it organically minimizes complexity.

401(k) withdrawal options prior to age 59½

Keep in mind you can rely on a few strategies to potentially avoid the 10% early withdrawal penalty on your 401(k). These include:

The Rule of 55
If you lose or leave a job and are between the ages of 55 and 59½, the Rule of 55 allows you to withdraw funds from your 401(k) account without penalty—but only applies to the 401(k) at your current job rather than previous employers.

401(k) loans
Most 401(k) plans allow you to access a portion of your retirement plan money (usually up to $50,000 or 50% of your assets, whichever is less) on a tax-free basis. In addition, most employers will allow you to borrow from your 401(k) for any reason.

You are required to pay back 401(k) loans—often within five years—and payments are generally deducted from your paycheck. However, if you borrowed money and then lost your job or changed employers, you’re generally only afforded 60 days to pay back the amount you owe.

Special circumstances
The IRS does allow penalty-free withdrawals under special circumstances: including IRS payments due to a levy, following the death of a participant (with money going to a beneficiary), or under a court order to direct money to a divorced spouse, child, or dependent.

Hardship withdrawals
If you need to withdraw a significant amount of money to meet an “immediate and heavy financial need,” you can potentially avoid the early withdrawal penalty—provided that your employer offers hardship withdrawals and that you qualify with the IRS. Expenses that meet IRS criteria for hardship withdrawals often include a sudden disability or medical expense debt that exceeds 7.5% of your adjusted gross income.

If you find yourself in one of these situations, be sure to check with your HR department to determine if your circumstances dictate free hardship withdrawals. If you do go this route, you’ll be prohibited from making elective contributions to your 401(k) for a period of 6 months.

Substantially equal periodic payment (SEPP) plans
SEPP plans allow you to receive a series of annual retirement account payouts for either five years or until you reach age 59½—whichever occurs later. If you decide to end these payouts prior to this time, you’ll need to pay an early withdrawal penalty and stop 401(k) contributions during this period. Keep in mind that you can use a SEPP plan with any 401(k) plan not held with your current employer.

Emergency distributions
You can withdraw up to $1,000 without penalty as an emergency distribution, with the option to repay the distribution over a span of three years (or fewer). Keep in mind, however, that other distributions are not allowed within that three-year period or until the money is repaid.

Required minimum distributions (RMDs)

Generally speaking, you’re required to withdraw a minimum amount of money from your 401(k) account when you turn 73 (beginning in 2033, this number climbs to 75). These requirements are called RMDs (or required minimum distributions) and also apply to all other employer-sponsored retirement plans: including 403(b) plans as well as traditional IRAs and IRA-based plans. The reason for the requirement? Uncle Sam wants you to pay taxes on these assets.

With RMDs, you can always withdraw more than the minimum amount required; however, tax implications may arise as this is taxed as ordinary income.

Alternatively, you could face a hefty penalty if you fail to take your RMD by the deadline—perhaps making you liable for a fee equal to 25% of the amount you didn’t take (or, perhaps, took in excess).

How changing jobs impacts your 401(k) options

After leaving a job, you’ll typically have at least 30 days to choose one of the following options:

Leave your savings with your current employer
Most companies will allow you to keep your retirement account right where it is provided you maintain a minimum account balance (typically $5,000). With this course of action, you can no longer contribute to this retirement plan and it will exist separate from any plans offered by your new employer—giving you one more account to manage. However, this decision is often worth it if your former employer's plan offers better options than your new company.

Roll over your savings into your new employer’s 401(k) plan
This is often a good choice provided you're satisfied with the investment options, costs, and features offered by your new employer-sponsored plan. Plus, you'll enjoy an opportunity to consolidate retirement plans—giving you one fewer account to manage. A key caveat? You’ll need to confirm your new employer’s 401(k) plan accepts rollovers.

Roll over your savings into an IRA
For most people, rolling a 401(k) into an individual retirement account (IRA) is often their best bet as IRAs offer nearly unlimited investment options whereas employer-sponsored 401(k) choices are more restricted.

An IRA can therefore allow you to invest your savings in any manner you’d like, whether via real estate or stocks, bonds, mutual funds, and/or ETFs. You can even select from a Roth IRA or traditional IRA—the choice is yours! Keep in mind, however, that tax implications are sometimes involved depending on your own individual circumstances.

If you plan on changing jobs at least a few times over the remainder of your career, an IRA can serve as a single platform for your previous retirement savings plans.

Cash out your savings
While it’s perhaps tempting to withdraw all of your cash as a bonus (referred to as a “lump-sum distribution”), this is almost always your worst option as you'll owe income tax on the amount withdrawn. Moreover, anyone under the age of 59½ is also subject to the afore-mentioned 10% early withdrawal fee while losing out on precious time for savings growth.

Keep vesting schedules in mind
No matter which path you choose, know that you may not be entitled to all the monies in your retirement account. Why is that, exactly? Many employer-sponsored retirement plans in fact follow a vesting schedule dictating employees must stay with the company for an extended period to realize the full value of employer-matching contributions.

With this in mind, take time to investigate your company’s vesting schedule; you may learn you’re mere days or weeks away from the next vesting cliff. In that case and if possible, it’s perhaps worth holding onto your current position a little longer.

Actions to take if your 401(k) balance seems too volatile

If your 401(k) account balance fluctuates more than you’d like—especially during market downturns—there’s a chance you’re investing too aggressively. In these situations, you (or your financial advisor) may need to reassess and readjust your risk tolerance: defined as your ability and willingness to stomach large swings in the value of your investments.

The higher the risk tolerance, the more likely your portfolio will include riskier investments such as stocks. A lower risk tolerance, meanwhile, could see more stable investments in your portfolio such as bonds or certificates of deposit (CDs). Failing to ignore risk tolerance in your 401(k) investment strategy is often a recipe for panic and might prompt an emotional reaction during market downturns, causing you to sell at the wrong time.

The “rule of 100” is one tool commonly used to gauge—at a high level—aggressiveness, dictating the proportion of stocks within any given portfolio. Using this strategy, you simply subtract your current age from 100 to learn which percentage of your investments to keep in stocks; safe assets such as bonds and CDs comprise the remainder.

Keep in mind that individual circumstances vary, so this rule isn’t for everyone. It’s also important to know that due to longer life expectancies, some experts have modified the rule to subtract any given age from 110 (or more!) to ensure you don’t run low on funds. The rule of 100 can also indicate the reverse: that you’re investing too conservatively.

When investing, remember that it’s ok to feel a little uncomfortable amidst any market downturns as you’ll need some level of exposure to stocks. That’s because while stocks are often very volatile, they are also one of the best ways to grow wealth over time. Hence, if your portfolio is too conservative, it’s perhaps not well-suited to meet your long-term goals.

The importance of 401(k) rebalancing

Whether you’re investing on your own or working with a financial advisor, you’ll need to nail down an “asset allocation”: the preferred percentage of stocks, bonds, etc., in your 401(k) based on your goals, risk tolerance, and investment time horizon to align with your needs as well as your temperament.

An established target allocation will then require ongoing maintenance, as market values fluctuate over time alongside the value of your investments. Rebalancing—the act of adjusting (buying and selling) your investments to restore your portfolio’s allocated percentages to their original makeup—shines through as the most common tool used to maintain target asset allocations.

Let’s assume your desired asset allocation reflects 60% stocks and 40% bonds and that, over time, market fluctuations shift this allocation to 70% stocks and 30% bonds. In this example, your financial advisor would simply rebalance your portfolio to return your current investment allocations to their original percentages: accomplishing this by selling investments that have increased in value (selling high) while buying others that have decreased but still have merit (buying low). This also optimizes the overall value of your portfolio.

The bottom line on 401(k)s

A 401(k) provides an easy way to kickstart the retirement savings process, especially since owning an account comes with several tax advantages. As many employers will also match a portion of your savings, there’s simply no reason not to open a 401(k) account if you’re eligible.

Still have questions about your 401(k)? Schedule a FREE Discovery call with one of our financial advisors today.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.