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Understanding 401(k) Plans: The Basics

A 401(k) plan is a workplace retirement savings program that allows workers to set aside money from their paychecks before taxes are taken out. The name comes from the section of the Internal Revenue Code that created it. Many employers offer 401(k) plans as an employee benefit, though not all do.

Here's how the basic structure works: You decide what percentage of your paycheck you want to contribute, and that money goes into your retirement account. Your employer may also contribute money to your account—this is called a match. For example, an employer might match 50% of what you contribute, up to 6% of your salary. If you earn $50,000 per year and contribute $3,000 (6%), your employer might add $1,500 to your account that year.

The money in your 401(k) account grows over time through investment earnings. You can choose from different investment options—typically mutual funds or target-date funds—depending on what your employer's plan offers. Target-date funds are designed to automatically adjust their mix of investments as you get closer to retirement.

According to the U.S. Bureau of Labor Statistics, about 51% of private-sector workers have access to a 401(k) or similar retirement plan through their employer. However, access varies significantly by company size and industry. Larger companies are more likely to offer these plans than small businesses.

One important feature of 401(k) plans is that the money you contribute reduces your taxable income for the year. If you contribute $6,000 to your 401(k), you only pay income tax on the remaining portion of your salary. This tax advantage is one of the main reasons these plans are popular for retirement savings.

Practical Takeaway: Review your current paycheck to see if your employer offers a 401(k) plan. Check any benefits paperwork you received when you started your job, or ask your human resources department what retirement plans are available to you.

How 403(b) Plans Work for Nonprofit and Education Workers

A 403(b) plan operates similarly to a 401(k) but is designed for employees of nonprofit organizations, public schools, colleges, and certain other institutions. The name refers to the section of the tax code that governs it. If you work for a hospital, university, public school, religious organization, or nonprofit charity, you may have access to a 403(b) plan instead of a 401(k).

Like a 401(k), a 403(b) allows you to contribute pre-tax money from your paycheck for retirement. Your employer may also make contributions. The money grows tax-deferred, meaning you don't pay taxes on the earnings until you withdraw the money in retirement.

The main differences between 403(b) and 401(k) plans involve the investment options and administrative structure. Most 403(b) plans invest in annuities or mutual funds. An annuity is a contract with an insurance company that guarantees payments to you during retirement. Some 403(b) plans offer mutual fund options as well.

According to the Government Accountability Office, approximately 10 million public school employees and 3 million college and university employees have access to 403(b) plans. These are substantial numbers in the education sector alone.

Contribution limits for 403(b) plans in 2024 are $23,500 per year, the same as 401(k) plans. Employees age 50 and older can contribute an additional $7,500 as a catch-up contribution. Many nonprofit employers do match employee contributions, though the matching varies widely by organization.

One unique aspect of 403(b) plans is that some employers allow multiple vendors to offer plans. This means you might have choices about which provider to use, and you could potentially have accounts with different vendors. This requires more careful management on your part to keep track of all your accounts.

Practical Takeaway: If you work for a school, nonprofit, or religious organization, ask your human resources or benefits department what 403(b) options are available. Request information about employer match policies and investment choices offered through your plan.

Contribution Limits and How Much You Can Save

Understanding contribution limits is important because it determines the maximum amount you can save in these plans each year. The Internal Revenue Service sets these limits, and they change periodically to account for inflation.

For 2024, employees can contribute up to $23,500 to either a 401(k) or 403(b) plan. This represents the amount you personally contribute from your paycheck. Your employer's contributions on top of this amount do not count toward your personal contribution limit, but there are overall limits on how much total money can go into your account each year—currently $69,000 for 2024.

If you are age 50 or older, you may make catch-up contributions of an additional $7,500 per year. This provision acknowledges that some workers want to save more for retirement as they approach their retirement years. So in 2024, workers age 50+ can contribute up to $31,000 personally to these plans.

Here's a practical example: Sarah is 35 years old and earns $65,000 per year. She decides to contribute 10% of her salary, which is $6,500 annually. Her employer matches 50% of contributions up to 6% of salary, so they contribute $1,950. Her total account growth that year comes from her $6,500 contribution plus the employer match of $1,950, plus whatever investment gains occur—a total of $8,450 before investment returns.

The contribution limits also apply to catch-up contributions for those age 50 and older. If Marcus is 52 years old, earns $80,000, and wants to maximize his retirement savings, he could contribute $31,000 in 2024 (the $23,500 base limit plus the $7,500 catch-up). However, this would need to come from his paycheck, so his take-home pay would be reduced accordingly.

It's worth noting that contribution limits change annually. The IRS typically announces the new limits in October or November for the following year. Organizations that maintain retirement plans usually update their employee communications about these changes.

Practical Takeaway: Calculate what percentage of your salary you can afford to contribute without stretching your monthly budget too thin. Even if you cannot reach the maximum limit, contributing something is better than nothing for long-term retirement security. Many financial professionals suggest starting with 3-5% and increasing your contribution by 1% each year.

Tax Advantages and How They Work

One of the primary reasons people use 401(k) and 403(b) plans is the significant tax advantages they offer. Understanding these advantages helps explain why these plans are so popular for retirement savings.

When you contribute money to a 401(k) or 403(b) plan, that money is deducted from your gross income before federal income tax is calculated. This means your taxable income is reduced by the amount you contribute. If you earn $50,000 and contribute $5,000 to your 401(k), you only pay federal income tax on $45,000.

Let's use a concrete example: Jennifer earns $60,000 per year and is in the 22% federal income tax bracket. If she contributes $6,000 to her 401(k), she saves $1,320 in federal taxes that year (22% of $6,000). Over a 30-year career, this type of savings can add up significantly.

The money in your account also grows tax-deferred. This means if your investments earn $2,000 in gains during a year, you don't pay taxes on those gains that year. The earnings stay in your account and continue to grow. You only pay taxes when you withdraw the money, typically after age 59½ in retirement.

This tax deferral is powerful over long periods. A dollar invested at age 35 has more time to grow than a dollar invested at age 50. By delaying taxes on investment earnings, more of your money stays invested and continues growing. This is sometimes called "compound growth" or "compounding."

There is a tradeoff to keep in mind: when you withdraw money in retirement, those