Understanding the Ins and Outs of Workplace 401(k) Plans

Vladimir Kouznetsov, EA, CFP®
Vladimir Kouznetsov, EA, CFP®

July 28, 2023

Invest in Your Future: Deciphering the 401(k) Puzzle

While considering future financial stability, a 401(k) plan stands as one of the most advantageous options available today. Named after the section of the U.S. tax code that establishes it, the 401(k) has become the retirement plan of choice for many businesses across the country. If you're unfamiliar with how this plan works or the potential benefits it could bring to your financial portfolio, let's delve into the details.

What is a 401(k) Plan?

A 401(k) plan is a qualified retirement savings plan offered by many employers in the United States. It allows employees to save and invest a portion of their paychecks before taxes are taken out. Notably, the funds aren't taxed until they're withdrawn.

The history of the 401(k) plan offers insight into how this retirement savings tool has evolved into its current form. The 401(k) did not originate as a purposeful retirement plan but was born out of a small provision in the Revenue Act of 1978.

Section 401(k) of this Act included a provision allowing employees to avoid taxation on deferred compensation. Interestingly, the provision's primary purpose was not to establish a new retirement savings vehicle but to limit the use of executive cash deferral plans.

The potential for 401(k) plans to act as a savings tool was recognized by benefits consultant Ted Benna in 1980. Benna, working for The Johnson Companies, interpreted the provision to create a simple, tax-advantaged way that ordinary employees could save for retirement. He designed the first 401(k) plan for his own company, which caught the attention of the Internal Revenue Service (IRS) and the Treasury Department. In 1981, the IRS issued new rules allowing employees to fund 401(k) plans through payroll deductions, marking the true beginning of the 401(k) plan as we know it today.

Initially, the plans were met with skepticism. However, with the decline of pension plans in the 1980s, employees needed a new way to save for retirement. The 401(k) plan quickly gained traction. By the end of 1983, nearly half of all large firms were offering a 401(k) plan, with many more planning to introduce one.

In 2001, the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) made significant changes to the 401(k) landscape, increasing contribution limits and introducing catch-up contributions for those over 50. The Roth 401(k) option, which allows for contributions on an after-tax basis, was introduced in 2006.

Today, 401(k) plans are a staple of American retirement planning, with millions of workers participating and trillions of dollars invested. The tax advantages, flexibility, and potential employer matching have made them a critical tool in the financial planning arsenal. However, they also require careful management, illustrating the importance of financial literacy and planning for every employee.

How the plan works

Now look at the basics of how 401(k) plans operate and how you can use them to build your retirement nest egg.

Employee Contributions

As an employee, you can contribute a certain percentage of your salary to your 401(k) account, subject to annual limits. As of 2023, the limit for employees under 50 was $22,500 per year, and the catch-up contribution for those aged 50 and over was an additional $7,500. These limits are indexed to inflation and change from year to year.

In some 401(k) plans, participants are allowed to make additional after-tax contributions over and above the standard contribution limit. The total contributions to a 401(k) from both the employee and employer in 2023 can go as high as $66,000 (or $73,500 for those aged 50 or older). This limit includes the standard employee contribution, employer matching contributions, and after-tax contributions. This means that if your plan allows it, and if your combined standard and employer matching contributions don't reach these total limits, you can contribute the difference as additional after-tax funds. These after-tax contributions can potentially be converted to Roth 401(k) or Roth IRA funds, subject to certain rules and restrictions (see “Mega Backdoor Roth” section below). Always consult with a tax professional or financial advisor for personalized advice.

Employer Matching

Many employers offer a matching contribution up to a specific percentage of the employee's salary. For example, an employer may match 100% of employee contributions up to 3% of their salary. Some employers even provide a profit-sharing contribution, which can vary from year to year.

Employer matching essentially equates to free money. Therefore, it's strongly recommended that employees contribute at least enough to their 401(k) to receive the full employer match.


Vesting in a 401(k) plan refers to the ownership of the employer's contributions to your account. While your own contributions are always 100% vested, meaning fully owned by you, employer contributions are typically subject to a vesting schedule. This schedule determines how long you must stay with your employer before you fully earn the right to these contributions.

Vesting schedules come in two main forms: cliff and graded. Under the cliff vesting, you earn full rights to your employer's contributions after a set period, often two or three years. If you leave before this time, you forfeit these contributions. Graded vesting gradually gives you rights to these contributions over time, often over five or six years. Knowing your plan's vesting schedule is crucial, especially if you're considering changing jobs, as it can significantly impact your retirement savings.

Plan Custodian

In a 401(k) plan, the assets are held by a third-party entity known as a custodian. This financial institution's role is to safeguard customers' assets, manage transactions, maintain records, and ensure compliance with IRS and Department of Labor regulations. A custodian's responsibilities do not extend to providing investment advice but are centered on administrative tasks and regulatory adherence.

The selection of a 401(k) custodian is a significant decision usually made by your employer or plan sponsor. Critical considerations include the custodian's expertise and experience in managing 401(k) assets, the range of services they offer, their security measures, the transparency and reasonableness of their fees, and the quality of their customer service. While a custodian plays a vital role in a 401(k) plan's operation and safeguards its assets, individual participants are responsible for their own investment decisions aligned with their retirement objectives.

In a typical 401(k) plan, participants cannot select their own custodian. This is because a 401(k) is a group plan, and it wouldn't be practical or efficient for each participant to select their own custodian. The plan sponsor has a fiduciary duty to act in the best interest of the plan participants, and this includes selecting a reputable, reliable custodian who charges reasonable fees for their services.

However, if you leave your job, you typically have the option to roll over your 401(k) into an Individual Retirement Account (IRA). At this point, you would have the ability to select the financial institution and, therefore, the custodian of your IRA.

Remember, choosing a custodian is an important decision, as it can affect the types of investments available, the fees you'll pay, and the services you'll receive. Always research your options thoroughly and consider seeking advice from a financial advisor if needed.

Investment Options

401(k) plans typically offer a limited range of investment options. The investment options available in a 401(k) plan are generally selected by the employer, often in conjunction with the plan administrator or a hired financial advisor. This process involves careful consideration to ensure the investment lineup is diverse and suitable for the range of employees who will be participating in the plan.

The selection of investment options typically includes a mix of asset classes such as stocks, bonds, and money market funds and may also offer target-date funds. These are designed to cater to varying levels of risk tolerance and investment horizons among the plan's participants. Each fund carries a different level of risk and potential return, making it important to align your investment choices with your financial goals and risk tolerance. The plan administrator is responsible for providing participants with information about the selected investment options, including potential risks and returns.

It's important to note that while the employer selects the available investment options, the responsibility for choosing specific investments within these options lies with the individual plan participant. This is why it's crucial for each participant to have a clear understanding of their own financial goals, risk tolerance, and investment knowledge. Participants are encouraged to seek independent financial advice if needed.

Tax Benefits of Traditional and Roth 401(k) Plans

From a tax perspective, 401(k) plans come in two flavors called traditional 401(k) and Roth 401(k). Both traditional and Roth 401(k) plans offer significant tax advantages, though the timing of those advantages differs. Understanding these benefits can help you make the most of your retirement savings.

Traditional 401(k) Plans

Contributions to a traditional 401(k) plan are made pre-tax, which means they reduce your taxable income for the year in which they are made. For example, if you earn $75,000 a year and contribute $10,000 to your traditional 401(k), you would only be taxed on $65,000 of income.

The funds in your traditional 401(k), including any investment gains, grow tax-deferred. This means you don't pay taxes on the investment returns while the money is in the account. However, when you begin to take distributions from your 401(k) in retirement, those distributions are taxed as ordinary income. In essence, you are deferring your tax liability until you retire, at which point you may be in a lower tax bracket.

Roth 401(k) Plans

Roth 401(k) plans work a bit differently. Unlike the traditional 401(k), contributions to a Roth 401(k) are made with after-tax dollars. This means your contributions don't lower your taxable income in the year they are made. However, the major advantage of the Roth 401(k) comes at retirement.

With a Roth 401(k), your money grows tax-free, and when you take distributions in retirement, those distributions are tax-free, provided you are at least 59 1/2 years old and have held the account for at least five years. This can be a significant advantage if you anticipate being in a higher tax bracket in retirement or if you believe tax rates will be higher in the future.

Choosing Between Traditional and Roth

Deciding between a traditional and Roth 401(k) largely depends on your current tax situation, your expectations for future income, and your retirement goals. Both plans provide valuable tax benefits that can help you grow your retirement savings more efficiently. Speaking with a financial advisor can provide personalized advice based on your individual circumstances and help you optimize your retirement planning strategy.

Penalties for Early Withdrawal

In general, 401(k) distributions prior to the age of 59 1/2 are subject to a 10% early withdrawal penalty, along with being taxed at regular income tax rates. However, hardship conditions and other special circumstances can lead to exceptions.

One notable exception is the age 55 rule. This provision allows the bypassing of the 10% penalty if you depart from your job in or after the year you reach 55. It's crucial to note that this rule is solely applicable to funds in a 401(k) or 403(b) from the job you left at age 55 or beyond, excluding funds in IRAs or 401(k)s from previous employers. This exception offers enhanced flexibility for individuals contemplating early retirement or those who are unexpectedly unemployed. As tax-related matters can be complex, it's always recommended to seek advice from a tax professional before making any decisions.

In addition to the age 55 rule, the IRS permits early, penalty-free distributions from your 401(k) under several other circumstances. These include distributions due to complete and permanent disability, distributions to an estate or beneficiary upon the death of the account holder, and distributions taken as a series of substantially equal payments based on your life expectancy. Other circumstances where the penalty may be waived include qualified reservist distributions, distributions to satisfy an IRS levy, and distributions up to the amount of your deductible medical expenses that exceed 7.5% of your adjusted gross income. Additionally, up to $10,000 used for a first-time home purchase may be exempt from the early withdrawal penalty. While these distributions may evade the 10% penalty, they typically remain subject to regular income tax. Always seek advice from a tax advisor to fully understand the implications before making an early distribution from your 401(k).

401(k) Rollovers

If you change jobs, you typically have several options for your 401(k): leave it with your old employer, roll it into a 401(k) at your new employer, roll it into an Individual Retirement Account (IRA), or cash it out. The last option generally comes with penalties, so it's often best to consider one of the first three options.

If you're considering rolling over your 401(k) to an Individual Retirement Account (IRA) or another 401(k), it's essential to be aware of the 20% mandatory withholding rule. When you take a distribution from your 401(k) to roll over, the plan administrator is typically required by the IRS to withhold 20% of the amount for federal income taxes if the money is paid directly to you. This means if you intend to roll over the full amount, you'll need to replace the 20% withholding out-of-pocket when you deposit the funds into the new account. If you don't replace it, the IRS will consider that 20% as a taxable distribution, potentially subjecting you to income taxes and an early withdrawal penalty if you're under the age of 59 1/2. However, you can avoid the withholding by executing a "direct" or "trustee-to-trustee" rollover, where the funds move directly from one account to another without passing through your hands.

Net Unrealized Appreciation (NUA)

Net Unrealized Appreciation (NUA) is a tax strategy that can be utilized when employer stock is held within a 401(k) plan. It offers potential tax advantages during lump-sum distributions. In normal circumstances, such distributions are taxed at your ordinary income rate. However, if your 401(k) includes employer stock, you'll only pay the ordinary income tax on the original cost basis of the stock, not its current market value. The appreciation above the cost basis, or the NUA, isn't taxed until you sell the stock, at which point it is taxed at the typically lower long-term capital gains rate.

There are specific requirements and potential risks for the NUA strategy. A lump-sum distribution must be made, and the entire 401(k) balance must be distributed within one tax year. Typically, distributions should occur after reaching age 59 1/2, after job termination, or due to disability or death. The NUA strategy is most beneficial when the cost basis is low and the NUA is high. However, risks include a potential drop in the employer's stock value post-distribution and overconcentration of retirement savings in a single stock. Therefore, it's crucial to consult with a tax professional or financial advisor before deciding to use this strategy.

“Mega Backdoor Roth” Tax Strategy

The Mega Backdoor Roth is a strategy that allows high-income earners to contribute additional funds to their Roth 401(k) or Roth IRA beyond the standard contribution limits. This is done by making after-tax contributions to a traditional 401(k) that allows such contributions and then converting those funds to a Roth account. The advantage lies in the ability to potentially contribute tens of thousands of dollars a year to a Roth account, where the money grows tax-free and qualified withdrawals are also tax-free. However, this strategy isn't available to everyone. It requires that the 401(k) plan allows after-tax contributions over and above the standard limit and in-service withdrawals or conversions. It's also a complex strategy that can have significant tax implications, so it's advised to seek advice from a tax professional or financial advisor before attempting it.


A 401(k) plan is a powerful tool for saving for retirement, offering tax advantages, the potential for an employer match, and a variety of investment options. It's never too early or too late to start contributing to a 401(k), especially when considering the power of compounding returns over time.

Remember, each person's financial situation is unique, so it's wise to consult with a financial advisor to ensure your retirement strategy aligns with your long-term financial goals. Whether you're just starting in your career or looking towards retirement, understanding how a 401(k) works can help you secure a comfortable financial future.

Vladimir Kouznetsov, EA, CFP®

July 28, 2023


This information has been derived from sources believed to be accurate. Please note - investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.

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Vladimir Kouznetsov, EA, CFP® is an investment advisor representative at Retegy LLC.
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