Paladin – What is a 401(k) and how Does a 401(k) Work?


Named after the section of the US Internal Revenue Code under which this retirement planning account is defined, 401(k) accounts are company-sponsored, tax-advantaged, and defined contribution plans where you can contribute pre-tax dollars. As an employee, one may contribute up to $19,500 per year for 2021 if they opt in for this plan. This cap on employee contribution is changed periodically by the IRS.

As an employer-sponsored account, your employers may also put money into your 401(k) plans, often matching your contribution in the account or up to 10% of your salary (whichever is lower). Some employers even offer to make a contribution on behalf of the employee. As per a 2019 report from the Vanguard Group, nearly half of the employers made matching contributions, an average of 3% of the employee’s salary, towards their 401(k) plan.

A company that offers a 401(k) plan invests the funds, typically in a mutual fund of the investor’s choice. The employee may choose from a variety of funds ranging from index funds, large-cap funds, foreign funds, real estate funds, or even bond funds. The investment is made with a long-term horizon in mind and the amount invested is tax-deferred; in other words, the investor needs to pay tax only upon withdrawal, once he or she has retired.

What is the contribution limit for a 401(k) plan?                                          

The IRS implies specific contribution limits for employees in a 401(k) plan. For 2021, the maximum contribution that you can make to a 401(k) account is $19,500. But if you are 50 years old or above, you can make an additional catch-up contribution of up to $6,500 in 2021.

In case you fall into a high earning category, the IRS allows you to use only the first $285,000 of your income when assessing your maximum contribution to a 401(k) plan.

On the basis of a joint contribution, that is, including employer and employee contributions, the upper contribution limit was set at $57,000 for 2020 and is $58,000 for 2021. For those 50 years or above in age, the limit was $63,500 for 2020 and is $64,500 for 2021.

What are the benefits of a 401(k) plan?

A 401(k) plan is a ‘qualified’ retirement plan, implying that the IRS provides special tax benefits on the funds invested in the account. As a retirement savings tool, some of the most important advantages include:

1. Matched employer contributions

It is optional for employers to contribute in full, or partially, or not at all in a 401(k) plan. However, most employers devote similar or partial money to their sponsored programs, over and above the paycheck of their employees. On average, it has been observed that employers often adopt a 50 cent-on-one-dollar approach. This means the employer puts in 50 cents into your 401(k) account for every dollar you contribute. Some employers also choose to follow a dollar-for-dollar approach.

2. Pre-tax contributions

401(k) plans allow you to make pre-tax contributions to your account. Your employer deducts your specified 401(k) contribution from your paycheck before the IRS makes its tax cut. This makes saving a bit easier as you are not paying taxes at the moment. Taxes on the amounts invested in 401(k) accounts is deferred into the future, when you begin taking distributions from the plan.

3. Lower-income tax

In addition to the savings boost,employer contributions, and pre-tax dollar savings, a 401(k) account also helps reduce your income tax burden.The money you contribute in a 401(k) plan lowers your taxable income for the year, which consequently reduces the annual tax charge. For example, if you earned $70,000 in a year and set aside $19,500 in your 401(k) for 2020, you would pay income tax only on $50,500, thus, shielding $19,500 from being taxed.

4. Tax-deferred growth

Another benefit of investing in a 401(k) account is that it offers you earnings on investments that are tax-free. However, once you begin your distributions from the account, that is, taking money out in installments, the money you take out will be charged at the income tax applicable rates. It is likely that you will not have income from a salary during your retirement period, thereby placing you in a lower tax bracket. This makes a 401(k) plan more appealing for retirement planning.


According to recent studies, a majority of Americans are concerned about not having enough money for retirement. One way to ensure a decent corpus to at least sustain your livelihood post retirement is to start planning your finances early in your earning years. An employer sponsored 401(k) account is a good place to start.

A 401(k) account allows you to save towards retirement during your healthy earning years. It is advisable for all investors with a 401(k) account to make the best of this opportunity by saving as much as they are able.

Did you know that you can rollover the amount accumulated in your 401(k) into an IRA without having to close your 401(k) account with your employer? Read our article on Should I roll my 401(k) into an IRA? to weigh your options.