What is a 401(k) and how does it work

Life adds up. Long-term financial health has been reframed by economic uncertainty and a stock market dip that caused 401(k) participants to lose $1.4 trillion from late 2021 to mid-2022.

But, as HR professionals like you know, businesses aren't giving up on their employees' financial future. A staggering 82% of employers told the Society for Human Resource Management they rank retirement planning as one of the most important benefits organizations can offer. In fact, 94% of companies offer 401(k) retirement plans and over half auto-enroll new hires into 401(k) plans.

Plus, greater financial wellness is a multigenerational concern. In a report from Deloitte, 43% of millennials and 47% of Generation Z cited their financial future as a major stressor. HR pros should expect a fresh wave of frequently asked questions surrounding 401(k) retirement plans and other financial matters.

Try not to look at this trend as an unreasonably tall order, but an opportunity to build trust with employees. Of course, you'll need to be ready to answer their inquiries accurately, quickly and confidently. But don't worry; this is our primer - packed with employees' common questions - to help cultivate financial wellness through 401(k) plans.

What is financial well-being?

The Consumer Financial Protection Bureau breaks down financial well-being into four pieces:

• control over daily and monthly finances
• freedom to enjoy life
• capacity to absorb a financial shock
• a clear path toward monetary goals

These factors cover financial security and choice now and in the future. Financial wellness is defined by more than an employee's present comfort. In fact, it encapsulates one's ability to reach their long-term goals. Generally, employees who feel financially secure are less inclined to burnout and more likely to stay with a company.

What is a 401(k)?

A 401(k) is a tax-deferred retirement savings plan offered by an employer. It's a contribution plan that allows participants to set aside portions of their pay without an immediate tax deduction. With a traditional 401(k) account, taxes aren't taken until money is withdrawn.

How 401(k) plans work

401(k)s let employees select their specific investments based on employer-provided options. Choices can include stock and bond mutual funds or target-date funds. Ideally, this lowers the risk of investment loss as participants near retirement.

Benefits of a 401(k)

Beyond the advantage of deferred taxes, 401(k)s normalize retirement planning for employees. They can think of 401(k) as a passive form of financial readiness. After deciding to contribute, employees don't need to keep up with the contribution on a monthly basis.

Instead, they have the luxury of adjusting their investment when they see fit. They might pivot when contribution limits change or a new investment opportunity presents itself.

Full-time employees

Full-time employees earning annual salaries are eligible to receive 401(k) benefits if their company provides them.

Part-time employees

In 2024, long-term, part-time (LTPT) employees who complete at least 500 hours of service over three consecutive years are eligible to contribute to their 401(k) plan. In 2025, the eligibility requirement will decrease to two consecutive years.

Self-employed

Self-employed people can establish a simplified employee pension (SEP) or contribute to a solo 401(k) plan, which lets participants contribute as both an employer and employee.

Employers

Employers can reduce their tax liability by contributing to their employees' 401(k) accounts.

Eligibility requirements for a 401(k) plan

Employees who are over 21 and have worked for your company for over a year must be offered a qualified retirement plan. A traditional 401(k) may require two years of service to receive an employer contribution if the plan specifies the participant is 100% vested in all plan account balances during their first two years.

Regardless, the plan must let employees make elective deferral contributions after a year of service.

401(k) contribution limits

Contribution limits generally rise each year; consider providing 401(k) news during benefits enrollment or shortly after compensation reviews.

2024 401(k) contribution limit

For 2024, employees may contribute up to $23,000 annually.

2025 401(k) contribution limit

For 2025, employees may contribute up to $23,500 annually.

401(k) catch-up changes

Employees over 50 have the option to make "catch-up contributions."

401(k) catch-up change in 2024

Employees age 50 and older are eligible for an additional $7,500 in catch-up contributions.

401(k) catch-up change in 2025

Employees age 50 to 59 or 64 and older are eligible for an additional $7,500 in catch-up contributions. Employees age 60 to 63 are eligible for an additional $11,250.

Tax implications of 401(k)

Taxes vary between a traditional 401(k) and a Roth 401(k) and depend on when funds are withdrawn.

Pretax contributions

Pretax dollars are used to make contributions, meaning taxes are paid when the money is taken out.

Posttax contributions

Posttax contributions are made with money that has already been taxed. These contributions grow tax-free and are tax- and penalty-free when withdrawn.

Where to report 401(k) contributions on Form W2

Employees contribute to 401(k)s on a pretax basis. Since employers already deduct 401(k) contributions from employees' taxable income, workers generally don't have to report the plans on their federal tax return.

How 401(k) accounts earn money

Employees can think of a 401(k) as a savings account with four ways to grow. In most cases, 401(k)s appreciate from:

• employee contributions
• employers' matching contributions
• the specific funds a 401(k) invests in
• compounding interest the 401(k) earns

Many of these factors rely on a set formula, making 401(k) growth a bit easier to predict. The performance of specific funds, however, can significantly alter the plan's compounding growth.

401(k) withdrawal rules

Beyond the normal taxes associated with both 401(k) plans, any plan distribution before an employee turns 65 (or sooner with some plans) may result in an additional income tax of 10% of the withdrawal's amount.

401(k) early withdrawals

A 401(k) withdrawal is considered early if it's taken before a participant is 59 and a half, barring further exceptions. It's impossible to account for everything, but championing employees' financial well-being may help offset the impact of disaster scenarios.

401(k) required minimum distributions (RMDs)

When retired employees turn 72, they must start receiving required minimum distributions, also known as "RMDs." On the other hand, active employees with 401(k)s or other workplace retirement plans may wait to receive payments until they formally retire. The only exception to this rule is if the active employee owns 5% of the business sponsoring the plan.

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

The primary difference between a traditional and Roth 401(k) is when taxes are applied.

Contributions to traditional 401(k) and Roth 401(k)

A Roth 401(k) takes contributions after an employee's income is taxed, so there are no further deductions when money is withdrawn.

Both methods have advantages depending on the economic climate, tax trends and personal factors. Providing employees with financial news and insight gives them the knowledge they need to make the best decision.

Average 401(k) balances by age

It's often the case that the longer someone invests in a 401(k), the higher its balance will be. According to Vanguard, an investment management company, a few decades can make a significant difference:

401(k) company match

Some businesses invest in their workforce's 401(k) accounts alongside employees. The amount contributed is left up to the employer, but most opt for either a dollar-for-dollar match (up to a certain percentage) or a partial deposit.

Both options are attractive to employees. Needless to say, most will favor a higher, matching contribution.

What happens to my 401(k) if I quit or change jobs?

Certain 401(k) balances are transferable. If the employee moves into an independent venture, an individual retirement account (IRA) could provide the option they need to continue safely saving for the future. However, it's a good idea to consider how IRAs differ from 401(k)s before investing.

What happens to my 401(k) if I die?

If a participant passes away, benefits they would have received usually are paid to a designated beneficiary.

Beneficiaries of 401(k) accounts

Employees can name anyone as a beneficiary, including family members, close friends or even a charitable organization. How these benefits are delivered, such as through an annuity or lump sum, is defined by the terms of the specific 401(k) plan.

401(k) loans

Borrowing from a 401(k) plan may be an option, but there are a few key considerations to keep in mind.

401(k) loan limits

According to the IRS, the maximum amount an employee may borrow is 50% of their vested account balance or $50,000, whichever is less. If 50% of the vested balance is less than $10,000, the employee may borrow up to $10,000.

Drawbacks of taking out a 401(k) loan

Employees who don't repay the loan, including interest, according to the loan's terms, may face consequences. Any unpaid amounts become a plan distribution to the employee.

In some cases, the plan may require immediate repayment in full if an employee leaves their job. Additionally, a 10% tax penalty may be applied to the taxable distribution amount, unless the employee is at least 59 and a half years old or meets another exception.

It's also worth noting that unpaid loan amounts can have a lasting impact on an employee's retirement savings. This is something to consider when educating employees on the potential risks and consequences of borrowing from their 401(k) plan.

Can 401(k) assets be used as collateral for a loan?

No, the IRS prohibits 401(k) funds from being used as collateral for a loan.

401(k) vs. 403(b)

While they're not too different in theory, a 403(b) - or a "tax-sheltered annuity plan" - is offered by public schools and certain 501(c)(3) tax-exempt organizations.

401(k) vs. IRA

401(k)s are designed for employees. IRAs, on the other hand, are available to anyone, such as independent contractors and small business owners. Although both offer similar tax advantages, IRAs have a lower contribution limit.

2025's limit for a traditional IRA is $7,000 or $8,000 for people over the age of 50. IRAs also have wider investment opportunities; even nonearning spouses can contribute to them.

How does HR support my financial future?

None of us can control the future. Instead, we anticipate and prepare for it. This is the essence of a solid financial wellness strategy. Helping employees be proactive is more effective - and sincere - than a guarantee.

Promoting programs for practical saving and retirement strategies gives employees a greater lease on their future. These can include money management classes, an on-site financial adviser or just helpful resources included in regular HR communication.

As employees approach retirement, they'll start to form a picture of what it'll look like. Without proper preparation, this period could spur stress. HR professionals like you can ease this transition by promoting responsible habits and incorporating financial wellness into company culture.

After all, supporting employees' financial well-being and helping them prepare for retirement shows that an organization cares about their future, not just its own. Remind employees to consult a licensed financial professional for in-depth investment advice.

FAQ

How can I calculate the best amount to contribute?

The amount depends on your individual financial goals and situation. A general rule of thumb is to contribute enough to take full advantage of any employer match.

Can I contribute to both 401(k) and IRA at the same time?

Yes. However, the deductibility of your IRA contributions may be limited or phased out depending on your income level and whether you or your spouse are covered by a workplace retirement plan.

Can I change my 401(k) investment choices?

The frequency at which you can make changes varies by plan, but most plans allow you to make them quarterly.

Can I choose to automatically increase my contributions?

Many 401(k) plans offer an automatic escalation feature, which allows you to increase your contributions by a fixed percentage or dollar amount at regular intervals.

Can I roll over my 401(k) funds into an IRA?

You can roll over your 401(k) funds into an IRA when you leave your job or reach age 59 and a half. This can be done directly, without having to take possession of the funds, to avoid any potential taxes or penalties.

Can 401(k) be converted to a Roth IRA?

You can convert your 401(k) funds to a Roth IRA, but this will require you to pay income taxes on the converted amount.

Where can I check my 401(k) balance?

You can typically check your 401(k) balance through your employer's HR portal, the plan administrator's website or by contacting the plan administrator directly.

How do I withdraw from my 401(k)?

Withdrawing from your 401(k) before age 59 and a half may result in a 10% penalty, in addition to income taxes on the withdrawn amount. You can withdraw from your 401(k) by contacting the plan administrator or through an online portal.

Why would a 401(k) be frozen?

A 401(k) plan may be frozen due to various reasons, such as a change in plan administrators, a merger or acquisition, or a plan amendment. During this time, you may not be able to make changes to your account or take withdrawals.

Are 401(k) plans FDIC insured?

401(k) plans are not FDIC insured.

Does the 60-day rollover rule apply to my 401(k)?

If you take a distribution from your 401(k) and do not roll it over into another qualified plan or IRA within 60 days, you may be subject to income taxes and penalties.

Can my 401(k) be garnished?

Your 401(k) account can be garnished, but only in certain circumstances, such as to satisfy a qualified domestic relations order (QDRO) or to pay taxes owed.

Should my 401(k) be deducted from severance pay?

Typically, 401(k) contributions are not deducted from severance pay, as severance pay is not considered regular compensation.

Should my 401(k) be deducted from bonus checks?

It depends on your employer's plan and the type of bonus. Some plans may allow 401(k) contributions to be deducted from bonus checks, while others may not.

What is a forced distribution?

A forced distribution occurs when a plan participant is required to take a distribution from their 401(k) account, usually due to a plan amendment or termination.

How does a 401(k) work when you retire?

When you retire, you can typically take distributions from your 401(k) account, which may be subject to income taxes. You may also be able to roll over your 401(k) funds into an IRA or take a lump-sum distribution.

Do 401(k) plans have beneficiaries?

401(k) plans allow you to designate beneficiaries who will receive the account balance in the event of your passing.

Does a 401(k) beneficiary pay taxes?

The beneficiary will be required to pay income taxes on the distribution they receive.

Can a 401(k) be put in a trust?

You can name a trust as the beneficiary of your 401(k) account, which can provide additional protection and control over the distribution of your assets.

Can a 401(k) be inherited?

Your 401(k) account can be inherited by your designated beneficiary.

Today's workforce wants more than just a 401(k) plan. Learn how to create a benefits package that meets the changing needs of the modern employee and sets your organization apart from the competition.

And check out how Paycom's 401(k) Reporting tool eases and automates retirement plan management for employers.

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