401(K) PLANS
EXPLAINED

A 401(k) investment plan offers US citizens a way to plan for their financial future. The scheme which is offered by employers provides a tax-advantaged way of building wealth for the future. This is what you need to know about what they are and how they fit into a comprehensive investment strategy.

---

For many US investors, a 401(k) plan is the cornerstone of their retirement savings strategy. This article will delve into the mechanics of 401(k)s, explore their various benefits and potential drawbacks, and help you make better-informed decisions for your long-term financial well-being.

This product/service is only offered to US clients

What is a 401(k) Plan?

A 401(k) plan is an employer-sponsored account that has become the primary retirement savings vehicle for millions of Americans. It allows you to make annual contributions (up to a specific limit) and invest that money for your later years.

Defining the 401(k): Employer-Sponsored Retirement Plan

A 401(k) plan is a tax-advantaged retirement savings account offered by employers to their employees. Named after Section 401(k) of the Internal Revenue Code, these plans allow workers to save and invest a portion of their paycheck before taxes are deducted. The money grows tax-deferred until withdrawal, typically during retirement, when many investors find themselves in a lower tax bracket.

Employers establish these plans with specific rules and investment options, often partnering with financial services companies to administer them. Unlike pensions, where employers guarantee specific benefits, 401(k)s place the investment risk and reward with the employee.

Key Terminology: Participant, Vesting, Beneficiary

Several key terms are crucial for understanding how 401(k)s operate:

• Participant: Any eligible employee who contributes to the plan
• Vesting: The process by which you gain full ownership of employer contributions over time
• Beneficiary: The person(s) who will receive your 401(k) assets if you pass away

Vesting schedules vary by employer, but typically follow either a cliff vesting approach (100% vested after a specific period) or graded vesting (gradually vesting over several years). Understanding your vesting schedule is crucial, as unvested employer contributions are forfeited if you leave the company.

Traditional 401(k) vs. Roth 401(k): Understanding Tax Implications

It is important to understand the difference between Traditional and Roth 401(k)s. While similar, the two schemes offer tax-efficiency at different ends of the investment timeline. A Traditional plan reduces the tax burden now, while a Roth (401(k) is more tax-efficient when you withdraw funds.

Here’s a comparison:

Feature	Traditional 401(k)	Roth 401(k)
Tax on contributions	Pre-tax (reduces current taxable income)	After-tax (no current tax benefit)
Tax on withdrawals	Taxed as ordinary income	Tax-free if qualified
Required minimum distributions	Yes, starting at age 73	Yes, starting at age 73
Income limits	None	None (unlike Roth IRAs)

How Do 401(k) Contributions Work?

A 401(k) is a long-term plan and it pays to spend time making sure you understand how they work, including how contributions are made, contribution limits, and the potential benefits of employer matching.

Employee Contributions: How Much Can You Contribute?

The IRS sets annual contribution limits for 401(k) plans, which typically increase with inflation. For 2025, the employee contribution limit is $23,500, with an additional $7,500 catch-up contribution allowed for those aged 50 and over. These limits apply to the combined total of Traditional and Roth 401(k) contributions.

Pre-tax contributions reduce your current taxable income dollar-for-dollar, providing immediate tax savings. For example, if you earn $80,000 and contribute $10,000 to a Traditional 401(k), your taxable income drops to $70,000. Roth contributions, while made with after-tax dollars, offer tax-free growth and tax-free withdrawals in retirement.

The Power of Employer Matching: A Key Benefit

Employer matching is essentially free money and one of the most compelling reasons to participate in a 401(k). If your employer offers a 50% match on the first 6% of your salary and you earn $60,000, contributing $3,600 (6%) would generate an additional $1,800 in employer contributions.

Common matching formulas include:

• 50% match on the first 6% of salary contributed
• Dollar-for-dollar match of up to 3% of salary
• Graduated matching (e.g., 100% on first 3%, 50% on next 2%)

Automatic Enrollment and Escalation Features

Many employers now implement automatic enrollment, signing up new employees at a default contribution rate (often 3–6% of salary). Automatic escalation features gradually increase your contribution percentage each year, helping you to save more over time without feeling the pinch.

Investment Options Within a 401(k)

Your 401(k) investment choices determine how your retirement savings grow over time. Understanding these options will help you to build a portfolio aligned with your risk tolerance and time horizon.

Typical Investment Choices: Mutual Funds, ETFs, Target-Date Funds

Most 401(k) plans offer a curated selection of investment options:

• Mutual funds: Professionally managed pools of stocks, bonds, or both
• Exchange-traded funds (ETFs): Similar to mutual funds, but traded like individual stocks
• Target-date funds (TDFs): Automatically rebalance from stocks to bonds as you approach retirement

Target-date funds have become increasingly popular for their “set it and forget it” approach. Simply choose a fund with a target date close to your expected retirement year, and the fund manager handles the asset allocation adjustments over time.

Understanding Risk and Return in Your 401(k) Selections

Balancing risk and return is crucial for long-term 401(k) success. Younger investors with decades until retirement can typically afford more aggressive, stock-heavy allocations, while those nearing retirement often shift towards more conservative bond allocations.

Consider your entire financial picture when selecting 401(k) investments. If you have other retirement accounts or taxable investment accounts, view your 401(k) as part of your overall asset allocation strategy rather than in isolation.

Self-Directed Brokerage Accounts (SDBAs) in 401(k)s

Some 401(k) plans offer self-directed brokerage accounts, providing access to a much wider range of investments beyond the plan’s core offerings. SDBAs allow participants to invest in individual stocks, additional mutual funds, and other securities.

While SDBAs offer greater flexibility, they require more investment knowledge and active management. They may also involve additional fees and lack the fiduciary oversight applied to the plan’s main investment menu.

Advantages and Disadvantages of Investing in a 401(k)

The benefits of 401(k) participation extend well beyond simple savings, offering multiple advantages that can significantly enhance your retirement preparedness. Despite this, 401(k)s have limitations that investors should understand to make well-informed decisions about their retirement strategy.

In addition, all investment growth within the account compounds tax-deferred. This means you won’t pay taxes on dividends, interest, or capital gains until withdrawal, allowing your money to grow faster than in a taxable account.

Managing Your 401(k) Throughout Your Career

Effective 401(k) management extends beyond simply making contributions. Strategic decisions throughout your career can significantly impact your retirement outcomes.

What Happens When You Change Jobs?

When leaving an employer, you typically have four options for your 401(k):

• Leave it with your former employer (if allowed)
• Roll it to your new employer’s plan
• Roll it to an IRA (direct or indirect rollover)
• Cash out (generally inadvisable due to taxes and penalties)

Direct rollovers, where funds transfer directly between providers, avoid tax withholding and potential penalties. Indirect rollovers require you to redeposit funds within 60 days to avoid taxation.

Early Withdrawals and Hardship Distributions: Rules and Consequences

While 401(k)s are designed for retirement, some plans allow hardship withdrawals for immediate financial needs such as medical expenses, home purchase, or eviction prevention. However, these withdrawals come with significant drawbacks which include:

• They are subject to income tax
• A 10% early withdrawal penalty (with limited exceptions)
• Cannot be repaid to the account
• Permanently reduces retirement savings

The IRS defines specific criteria for hardship withdrawals, and you must exhaust other options like 401(k) loans first.

Integrating Your 401(k) Into Your Broader Investment Strategy

Your 401(k) should not exist in isolation, but rather as part of a comprehensive investment strategy. Consider how your 401(k) holdings complement other accounts, including taxable investment accounts and IRAs.

Understanding your complete asset allocation across all accounts helps you to make better investment decisions. Modern portfolio tracking tools can aggregate multiple accounts, providing a holistic view of your investments and help you to maintain your target allocation while maximising tax efficiency.

Required Minimum Distributions (RMDs) in Retirement

Starting at age 73 (as of 2024), the IRS requires you to begin taking minimum distributions from Traditional 401(k)s. These RMDs are calculated based on your account balance and life expectancy, forcing you to withdraw and pay taxes on a portion of your savings annually.

Failing to take RMDs results in a severe 25% penalty on the amount not withdrawn. Roth 401(k)s are also subject to RMDs, though the withdrawals are tax-free if qualified.

Final thoughts

The popularity of 401(k) plans speaks for itself. The fact that they offer tax-efficient investing and matching employer contributions makes them an obvious starting point for anyone looking to secure their financial future.

As they are a long-term scheme, it pays to invest some time now to establish if they are the right fit for you, and develop an understanding of how they work so that you can optimize the benefits they offer.

Visit the eToro Academy to learn more about tax-efficient investing.

FAQs

What’s the difference between a 401(k) and an IRA?

The main differences include contribution limits. 401(k)s allow much higher contributions and only 401(k)s offer employer matching. IRAs typically offer more choices in terms of investment options and 401(k)s are employer-sponsored while IRAs are individually established.

Can I contribute to a 401(k) if I’m self-employed?

Yes, self-employed individuals can establish a Solo 401(k), also known as an Individual 401(k). These plans offer the same tax advantages and even higher contribution limits since you can contribute as both employee and employer.

How often should I review my 401(k) investments?

Review your 401(k) at least annually or when major life events occur (marriage, children, job change). Check your asset allocation, rebalance if necessary, and ensure your investment mix still aligns with your risk tolerance and time horizon.

Is the Roth IRA only for US investors?

Roth IRAs are specifically US retirement plans. They are only available to those with US taxable income. While US expats can contribute to IRAs if they have taxable earned income, their plan will be governed by US law and tax treaties, not by the rules of the country in which they live.

I’ve turned 73, what is the date that I need to make a Required Minimum Withdrawal by?

If you are 73 years old this year then the first RMD must be made by April 1 next year, or else you face penalties on the invested amount. Your second withdrawal will need to be made by December 31, next year.