Retirement Planning

401K Basics

A 401k plan is very important when it comes to retirement planning. If you're wondering how it works learn about contributions, tax benefits, withdrawals and even rollovers.

How Does a 401k Work: What you need to know for retirement planning

For many Americans, a 401k is the key to their retirement planning. Still, many workers don't understand how these plans work. To make sure you're prepared, we've outlined the most important information about a 401k plans.

Investing in a 401k

To invest in a 401k, you need to work at a company that offers one, or be the sole proprietor of a business (with no employees) and participate in an individual 401k. You can't open a 401k if you are unemployed. Once you're in a company-sponsored 401k, your company will tell you what percentage of your salary you can put away per year into the company plan. Some companies may also match your contributions.

For example, a 401k plan might let you invest a percentage of your salary each year and your company would match 50 cents for every dollar you add to your account up to three percent of your salary. The company match is free money, and it's usually a good idea to invest the full percentage of the match.

401k Contribution Limits

Your company will tell you the maximum percentage of your salary you can add to the 401k each year. However, the government also limits how much you can invest in a 401k. As of 2015, you can add up to $18,000 a year to your account if you are younger than 50 and up to $23,000 if you are 50 or older. Each year, you can contribute the lesser of the plan's maximum percentage or the government limits.

The money in your account will be a mix of the contributions from your pretax earnings and your company's matching contributions, assuming your company offers that benefit. Your pretax earnings come out of your paycheck and will remain your money even if leave your job. The company match is a bit less certain. Many companies have restrictions on when the matching contributions actually become yours. This is called vesting. You usually need to stay with the company for a minimum number of years or else you could lose some or all of your matching contributions.

401k Tax Benefits

The money added to your 401k can be deducted from your taxable income. This helps you tackle two important financial goals: saving for the future while also bringing down your current tax bill.

Once your money is in a 401k, you'll be investing it in a variety of stocks, bonds, mutual funds and other investments. Typically, when you invest, you need to pay taxes on your investment earnings right away. Not with the 401k. As long as you keep your savings in this account, you can put off paying taxes on these gains until retirement.

Taking Money Out of a 401k

The 401k is a retirement plan so you are supposed to keep your money in the plan until you reach a certain age. If you leave your job, you can start taking penalty-free withdrawals from your 401k as soon as you turn 55. If you keep working past this age, you can start taking penalty-free withdrawals once you turn 59½.

When you take a retirement withdrawal, you'll need to pay income tax on that amount.

401k Early Withdrawal

Taking money out of your 401k before retirement can be difficult. First, your company plan needs to allow early withdrawals. Then, it gets expensive. The IRS charges an extra 10 percent penalty on top of income taxes on early 401k withdrawals. The penalty can be avoided in a few situations, such as paying for excess medical bills or college tuition.

You might also be able to take money out as a loan. When you take out 401k loans, you won't owe taxes or a penalty provided you pay the money back into your plan with interest. Once again, whether you can take a loan depends on your company's 401k withdrawal rules.

401k Rollover When Leaving Your Company

If you leave the company offering the 401k, you won't be able to add any more money to its plan. In this situation, it usually makes sense to take your retirement savings out the door with you, through an account rollover. When you roll over your old 401k, you transfer the account straight into another retirement plan, like an IRA or your new job's 401k, if allowed by your new employer. You won't owe any taxes on the move and can get right back to work investing as normal.

Managing a 401k takes some work but for most people, it's an important piece of saving for retirement. If you have questions, about this financial tool, consult a financial advisor.

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All Learning Center articles are general summaries that can be used when considering your financial future at various life stages. The information presented is for educational purposes and meant to supplement other information specific to your situation. It is not intended as investment advice and does not necessarily represent the opinion of Protective Life or its subsidiaries.

Neither Protective Life nor its representatives offer legal or tax advice. We encourage you to consult with your financial adviser and legal or tax adviser regarding your individual situations before making investment, social security, retirement planning, and tax‐related decisions. For information about Protective Life and its products and services, visit

Understanding 401(k) Plans.

At Protective, we believe that the more you understand about retirement options, the better you can plan and achieve your retirement goals. Understanding tools like a 401(k) is a good place to start. You'll find other information on this website and in our social channels to help you educate yourself about retirement options.