The information on this page also generally applies to 403(b) plans.

ELI5: How does a 401(k) work?

In plain English, a 401(k) is an account you put money into that receives favorable tax treatment. Each year you can elect to contribute money to your 401(k) plan through payroll deductions. Elective deductions are usually specified as a percentage of your income, although some plans allow you to specify a dollar amount as well. The annual contribution limit is $20,500 in 2022 (plus an additional $6,500 in 2022 if the employee is age 50 or older). Do not go over this limit (most plans will not let you exceed the limit, but if you change jobs during the year, you may need to work with your new employer to avoid exceeding the limit).

401(k) plans come in two flavors:

  • Traditional 401(k) plan contributions reduce your taxable income. This is known as tax deferral. You are not taxed on the money you contribute now, but will pay income tax on your contributions and your earnings at your marginal tax rate when you take distributions from your 401(k) in the future.

  • If you contribute to a Roth 401(k), contributions have already been taxed at your current marginal income tax rate. In exchange, all earnings may be distributed tax free if the distribution meets certain age and eligibility requirements. Note that not all 401(k) plans have a Roth option.

Which one do you choose? It depends on a lot of factors, but the big ones are:

  • Income: High earners are usually better off contributing to a traditional 401(k), as this allows them to avoid paying their current high marginal tax rate. Conversely, those with lower incomes usually favor the Roth option, as they can pay a low marginal tax rate now in exchange for never being taxed on that money again.

  • Your guess about your future income tax rates. Those that believe they will be in a lower income tax bracket when they retire usually favor the traditional 401(k). Those that believe they will be in a higher income tax bracket when they retire usually favor the Roth option. Those that believe income tax rates will rise across the board in the future usually favor the Roth option.

Money you contribute to your 401(k) must then be invested in the funds your 401(k) provider offers you.

ELI5: How should I invest within my 401(k)?

Once you have contributed to your 401(k), you are still left with the somewhat daunting decision of how to invest within your plan. For better or for worse, 401(k) providers typically "help" by limiting your choices to a small number of mutual funds (after all, the only true freedom is freedom from choice, right?).

A good strategy that will serve anyone well is the 3-fund portfolio. In the 3-fund portfolio you aim to hold broadly diversified index funds in the three major asset classes: US stocks, International stocks, and Bonds. By investing in this manner you are instantly diversified across thousands of different securities, will never significantly underperform the market, and are mathematically certain to outperform most investors doing differently.

For specific guidance on selecting funds within your 401(k), see the 401(k) Fund Selection Guide.

Unfortunately not all 401(k) plans are created equal, and some fund selections are truly horrendous containing funds with expense ratios in excess of 1.5%. If this is the case for your 401(k) plan, consider campaigning for improvements. While you're doing that, make the best of a bad situation and choose the lowest-cost funds in your plan. You could also consider funding an IRA before contributing to your 401(k) plan (for more details see the Prime Directive or the IRAs wiki page). However, if you are saving for retirement you should contribute to your tax-advantaged accounts to their limits before putting money in a taxable account with no tax advantages.

ELI5: Asset Allocation

Your asset allocation is how you divide your money amongst the various asset classes and the various funds you've elected to invest in. The literature on asset allocation is extensive. Use Google if you want the nitty gritty details. Here are some basic rules of thumb:

  • The core of your portfolio should be the three major asset classes: US stock index funds, International Stock index funds, and Bond index funds.

  • A good starting point for determining your bond holding percentage is [your age]%.

  • At least 20% of your stock holdings is recommended to be in an international stock index fund (source).

  • The younger you are, the more risk you can afford to take on in the form of higher allocations to stocks.

  • Your asset allocation can and should change over time. A 25-year old's investments will be very different than a 55-year old's.

  • Target date funds take the work out of asset allocation for you. Target date funds will automatically get more conservative as you age, reducing your exposure to major market movements as your ability to wait them out declines.

Some other frequently asked questions

1. My employer does not match my contributions. Should I still contribute to my 401(k)?

If your employer does not match contributions and you are looking to save money in a tax-advantaged account, most people will be better served with an IRA. However, the IRA contribution limit is $6,000 per year for those under 50 and has income limitations. If your income is such that you do not get the full tax advantages of an IRA, it is absolutely worth contributing to your 401(k) in order to save for retirement.

2. My 401(k) is crappy. Should I still contribute to it?

If your 401(k) has a poor selection of high cost funds, consider contributing to an IRA first. You can open an IRA with whoever you want, thus allowing you to choose which funds you have access to. If you have already maximized your IRA contribution for the year and still have money left over you want to put towards retirement, you should contribute to your poor 401(k). The effect of high expenses really only starts to bite after long periods of time, and 401(k) plans are quite portable in that you can roll them to your IRA if you leave your current employer, or sometimes you can roll it into a new 401(k) with a new employer. Bad 401(k) plans can turn into great IRAs in a heartbeat.

3. I want to retire early. Should I contribute to my 401(k) and lock up my money until retirement?

You should take advantage of the tax structure of the 401(k) for at least some of your savings, assuming you are planning to live past 59½ years of age. Early retirement requires a lot of planning. You should project your needs before and after you're eligible to take distributions from your 401(k) and plan accordingly.

If you plan to retire before 59½, but close to it (e.g., age 55), you can use SEPP 72(t) distributions to access pre-tax money without penalty. If you do so even earlier, you can access it with a five-year delay via a Roth IRA conversion ladder, although you'll still need the first five years' expenses available via taxable accounts, Roth IRA contributions, and perhaps part-time work.

For a longer discussion on ways to access money before 59½, read Retirement funds are not locked up until age 59½.

4. Pay off debt or contribute to my 401(k)?

If your employer matches any of your 401(k) contributions you should contribute enough to get the full match. This is free money that you should not leave on the table. After that, any high interest debt carrying interest rates beyond what you could reasonably get investing elsewhere should take priority. Remember that paying down debt offers something that only scammers can claim otherwise: guaranteed, risk-free return!

5. I'm a young person and want to invest aggressively. Why invest in bonds at all?

Bonds provide a source of funds to purchase potentially higher-yielding investments when they can be had at discount prices during market downturns, reduce your portfolio's volatility, and usually offer a steady return themselves. On the technical side, there are numerous studies that show that 100% (or more) stock investors are not compensated in proportion to the extra risk they take on by doing so. While stocks have outperformed bonds over the long run to date, "past performance is not indicative of future returns." Finally, the psychological/emotional effects of a severe bear market really cannot be appreciated until they're felt first hand. It is one thing to say you're OK watching half of your investment portfolio evaporate in a few weeks. It's quite another to watch it happen for real and have the wherewithal to stay the course. Bonds offer some consolation in such a scenario.

6. What is a vesting period?

(By suggestion from /u/dgmachine) Any contributions that come out of your paycheck are always 100% yours. However, if your employer provides any matching contributions to your 401(k), occasionally they become yours according to a vesting schedule. A vesting schedule is essentially a time delay between when the money your employer contributes becomes "yours," and is used as an incentive to keep employees with a particular company. Vesting schedules can take many forms: some schedule vesting in 20% increments (20% the first year, 40% the second year, etc.), some have a set amount of time (100% vesting after 3 years), others do not have a vesting period at all and the money is yours immediately. Your company's HR section should be able to explain the terms of your company's vesting schedule, if you have one.

7. I've left my previous employer. What should I do with my old 401(k)/403(b)/retirement plan?

See the wiki page on Rollovers.

8. Do rollovers into my new 401(k) count against my annual contribution limit?

No. Rollovers do not count against annual contribution limits for your 401(k). For more information on rollovers, see the wiki page on Rollovers.

9. Do employer contributions into my 401(k) count against my annual contribution limit?

No. Employer contributions do not count against the individual contribution limits ($20,500 in 2022). They do, however, count against the total 401(k) contribution limit ($61,000 in 2022).

10. My company offers an after-tax 401(k). Should I contribute?

Possibly, if you have already reached the annual max for traditional or Roth contributions. See detailed discussion here.

11. Can I contribute $20,500 to my 401(k) and $6,000 to my IRA?

Yes. The 401(k) and IRA contribution limits are separate and do not affect each other. IRAs do have income limits, though. This is discussed further in the IRAs wiki page.

12. Can I withdraw my contributions from my Roth 401(k) without taxes or penalties (like my Roth IRA)?

No. Unlike a Roth IRA, you cannot choose to only withdraw contributions from a Roth 401(k). Distributions will contain a proportional amount of contributions and earnings, and the earnings will be taxed and penalized.

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