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What Is a 401(k) and How Does It Work?

 

What Is a 401(k)?

A 401(k) is a retirement savings plan that provides tax advantages to savers. Named after a section of the U.S. Internal Revenue Code, the 401(k) is an employer-provided, defined contribution plan.1 The employer may match employee contributions; with some plans, the match is mandatory.

There are two major types of 401(k)s: traditional and Roth. With a traditional 401(k), employee contributions are pretax, meaning they reduce taxable income, but withdrawals in retirement are taxed. Employee contributions to Roth 401(k)s, on the other hand, are made with after-tax income. There's no tax deduction in the contribution year, but withdrawals—qualified distributions—are tax-free.2

Key Takeaways

  • A 401(k) plan is a company-sponsored retirement account in which employees can contribute a percentage of their income. Employers often offer to match at least some of these contributions.
  • There are two basic types of 401(k)s—traditional and Roth—which differ primarily in how they're taxed.
  • Employer contributions can be made to both traditional and Roth 401(k) plans.

"The most important thing to know when making any decision about your 401(k) is to use it. In a perfect world, you put the maximum amount in it, but at a minimum, you should contribute up to the point where your company matches what you put in," said Peter Lazaroff, financial advisor and chief investment officer at Plancorp.

In 2023, Americans saved an average of 7.1% of their salaries in their 401(k)s3, which was higher than the overall personal savings rate that year.4 Less than 12% of working-age Americans were on track in 2023 to "max out their retirement contributions",5 though the 401(k) employee contribution limit for 2023 was $30,000 (including "catch-up" contributions) for those 50 and older and $22,500 for those under 50. (In 2024, those numbers are $30,500 and $23,000, respectively.)6

Below, we walk you through how to start a 401(k), how 401(k) plans work, and strategies for making the most of them.

Investopedia / Ellen Lindner

How Do You Start a 401(k)?

  • Contact your employer. Ask if a 401(k) is available, and whether there is a company match.
  • If a 401(k) is available, the company will instruct you how to sign up with new paperwork.
  • Choose your investments. There should be a range of options, from conservative to aggressive. A popular option is the target date account, which automatically adjusts the asset mix to align with a preset retirement date. It typically becomes more conservative as you near retirement.7
  • If you are self-employed or run a small business with your spouse, you may be eligible for a solo 401(k) plan, also known as an independent 401(k).8 These plans allow independent contractors to fund their own retirement. A solo 401(k) can be created through most online brokers.

How 401(k)s Work

Introduced in the early 1980s, traditional 401(k) plans allow employees to make pre-tax contributions from their salaries up to certain limits.910

When workers sign up for a 401(k), they agree to deposit a percentage of each paycheck directly into an investment account. Employers often match part or all of that contribution, and employees can choose from a variety of investment options, typically mutual funds.11

History of the 401(k)

The U.S. has undergone a significant shift in how Americans save for retirement, as illustrated below by our chart comparing the number of Americans (in millions) in defined benefit and defined contribution plans, along with the total for both.

Defined contribution plans, most of which are 401(k)s, are an alternative to the traditional pension, known as a defined benefit plan. With a pension, the employer is committed to providing a specific amount of money to the employee for life during retirement.12 In recent decades, as the chart below shows, defined contribution plans like 401(k)s have become far more common, and traditional pensions have become rare as employers have shifted the responsibility and risk of saving for retirement to employees.1314

Direct contribution plans like 401(k)s allow employees to put part of their salary into individual accounts, often with matching funds from their employer. Their ultimate retirement benefits depend on the account's investment performance.

Comparing the Number of Americans in Defined Benefit vs. Defined Contribution Plans

Congressional Research Service.

Investopedia

Above, the number of Americans in defined benefit and defined contribution plans, along with the total of both, in millions.15

Initially offered by employers to supplement other employee benefits, 401(k)s have become the most common private employer-sponsored retirement program in the U.S. About a third of working-age Americans have a 401(k), compared with one in nine who have a defined benefit pension plan.10 Meanwhile, U.S. Census data suggests that as many as four in 10 Baby Boomers (aged 55 to 64) and half of Millennials (aged 24 to 39) have no retirement account at all.10

Still, the 401(k) plan was designed to encourage Americans to save for retirement. Among its benefits are tax savings. There are two main options, traditional and Roth, each with distinct tax advantages.

Traditional 401(k)

With a traditional 401(k), employee contributions are deducted from gross income. This means the money comes from your paycheck before income taxes have been deducted.

As a result, your taxable income is reduced by the total contributions for the year and can be reported as a tax deduction for that tax year. No taxes are due on the money contributed or the investment earnings until you withdraw the money, usually in retirement.16

Roth 401(k)

With a Roth 401(k), contributions are deducted from your after-tax income. This means you contribute from your pay after income taxes have been deducted. As a result, there is no tax deduction in the year of the contribution. When you withdraw the money during retirement, though, you don't have to pay any additional taxes on your contribution or on the investment earnings.

Even though contributions to a Roth 401(k) are made with after-tax money, there are, generally speaking, tax consequences if withdrawals are made before you're 59½. Always check with an accountant or qualified financial advisor before withdrawing money from either a Roth or traditional 401(k).

However, not all employers offer a Roth account option. If one is available, you can choose between a traditional and Roth 401(k). You can also contribute to both up to the annual contribution limit.17

401k Plan Contributions Explained

Traditional and Roth 401(k) plans are defined contribution plans. Both the employee and employer can contribute to the account up to the dollar limits set by the Internal Revenue Service (IRS).16 Employees' contributions to a traditional 401(k) plan are made with before-tax dollars and reduce their taxable income and their adjusted gross income. Contributions to a Roth 401(k) are made with after-tax dollars and do not impact taxable income further.

Employees are also responsible for choosing the specific investments held within their 401(k) accounts from a selection that their employer offers. Those offerings typically include stock and bond mutual funds and target-date funds designed to reduce the risk of losses as the employee approaches retirement.718

Note

An employee's account holdings may include guaranteed investment contracts issued by insurance companies and sometimes the employer's own stock.18

Contribution Limits

The maximum amount an employee or employer can contribute to a 401(k) plan is adjusted periodically to account for inflation, which measures rising prices.

For 2024, the annual limit on employee contributions to a 401(k) is $23,000 annually for workers under age 50. However, those aged 50 and over could make a $7,500 catch-up contribution.19

If your employer also contributes or if you elect to make additional, nondeductible after-tax contributions to your traditional 401(k) account, there is a total employee-and-employer contribution amount for the year:20

  • For workers under 50 years old, the total employee-employer contributions can't exceed $69,000 per year.
  • If the catch-up contribution for those 50 and over is included, the limit is $76,500.

Employer Matching

Employers who match employee contributions use various formulas to calculate that match.

For instance, an employer might match $0.50 for every $1 that the employee contributes, up to a certain percentage of salary. Vanguard estimates that about four in 10 companies have 401(k) matching contributions of up to 6% of their employees’ wages. Only 10% of companies offer more than that.21

Lazaroff, who also hosts the investment education podcast The Long Term Investor, said that if you can take advantage of your employer’s matching contributions, you should.22 It’s a risk-free way to grow your money and not leave part of your compensation on the table.

“Meeting the match doesn’t necessarily mean you have to sacrifice other financial goals, such as paying down debt or establishing an emergency fund,” he said. “You can still chip away at debt and put away small amounts in an emergency fund if necessary. But securing that employer match is crucial.”

Employer contributions can be made to a traditional 401(k) account and a Roth 401(k). Withdrawals from the former will be subject to tax, whereas qualifying withdrawals from the latter are tax-free.1617

Contributing to Both a Traditional and a Roth 401(k)

If your employer offers both types of 401(k) plans, you can split your contributions, putting some money into a traditional 401(k) and some into a Roth 401(k).17

However, the total contribution to the two types of accounts can't exceed the limit for one account ($23,000 for those under age 50 in 2024).2017

"Even though everyone has different circumstances, in general, you should try to put in the maximum allowable amount in your 401(k)," said Lazaroff, the Investopedia top-10 financial advisor.

How Does Your 401(k) Earn Money?

When you contribute to your 401(k) account, your money is invested according to your choices from the options your employer offers. These typically include an assortment of stock and bond mutual funds, as well as target-date funds designed to reduce the risk of investment losses as you approach retirement.

According to Lazaroff, target-date funds are the way "you're least likely to make mistakes." These accounts contain a mix of stocks, bonds, and other securities that are adjusted as your chosen date approaches, generally shifting toward more conservative investments as you near retirement.

"You might be different from the average, and you might accumulate enough wealth one day where a target-date fund isn't the most appropriate. But for many people, it's one of the easier and least risky routes to take if available in their plan allows it," Lazaroff said.

Several factors influence the pace and extent of your 401(k)s growth, including the amount you contribute annually, any company matches, investment performance, and the time until retirement.

A significant benefit of a 401(k) is tax-deferred growth. As long as you don't remove funds from your account, you don't have to pay taxes on investment gains, interest, or dividends until you withdraw money from the account after retirement. However, if you have a Roth 401(k), you won't have to pay taxes on qualified withdrawals when you retire, as contributions are made with after-tax dollars.2324

Crucially, opening a 401(k) when you are young allows your money to grow more over time, thanks to the power of compounding. Compounding occurs when the returns generated by your savings are reinvested into the account, generating returns of their own.

Over many years, the compounded earnings on your 401(k) account can exceed the amount you contributed. This is why, as you continue to contribute to your 401(k), it can grow quite substantially by the time you retire.

401(k) Withdrawals

Once your money goes into a 401(k), it can be difficult to withdraw without paying taxes on the amount.23

"Make sure that you still save enough on the outside for emergencies and expenses you may have before retirement," said Dan Stewart, the head of Dallas-based Revere Asset Management Inc. "Do not put all of your savings into your 401(k) where you cannot easily access it, if necessary."

Earnings in a 401(k) account are tax-deferred for traditional 401(k) accounts and tax-free for Roth accounts. When you withdraw from a traditional 401(k), that money (which has never been taxed) will be taxed as ordinary income. Roth account owners have already paid income tax on the money they contributed. Thus, you won't owe taxes on withdrawals if you satisfy specific requirements.2524

Both traditional and Roth 401(k) owners must be at least 59½—or meet other Internal Revenue Service (IRS) criteria, such as being totally and permanently disabled—when you start making withdrawals so you don't face any penalties.2317 Usually, there's an additional 10% early distribution tax on top of any other tax you owe if you withdraw early.2317

Some employers allow employees to take out a loan against their 401(k) plan contributions, essentially borrowing from themselves. If you take out a 401(k) loan and leave the job before repaying it, you'll have to repay it in a lump sum or face the 10% penalty for an early withdrawal.26

Required Minimum Distributions

Traditional 401(k) account holders have required minimum distributions (RMDs) after reaching a certain age. (Withdrawals are called distributions in IRS parlance.)27

Account owners who have retired must start taking RMDs from their 401(k) plans at age 73. The size of the RMD is calculated based on your life expectancy at the time. Before 2020, the RMD age was 70½ years old. Before 2023, it was 72.28 It was updated to age 73 in the omnibus spending bill H.R. 2617 in 2022.29

Note that distributions from a traditional 401(k) are taxable, but qualified withdrawals from a Roth 401(k) are not.24

Roth IRAs, unlike Roth 401(k)s, are not subject to RMDs during the owner's lifetime.30

Traditional 401(k) vs. Roth 401(k)

When 401(k) plans were first rolled out in the early 1980s, companies and their employees had one choice: the traditional 401(k).31 Then, in 2006, Roth 401(k)s arrived.32 Roths are named for former U.S. Senator William Roth of Delaware, the primary sponsor of the 1997 legislation that made the Roth IRA possible.33

At first, Roth 401(k)s caught on slowly, but now many employers offer them. So, the first decision employees often have to make is choosing between a Roth and a traditional 401(k).

As a general rule, employees who expect to be in a lower marginal tax bracket after they retire might want to opt for a traditional 401(k) and take advantage of the immediate tax break.

Employees anticipating a higher tax bracket after retiring might choose a Roth 401(k) to avoid paying taxes on their savings later. This decision could be especially worthwhile if the Roth has many years to grow, as all the money earned by the contributions over decades will be tax-free upon withdrawal.

As a practical matter, the Roth reduces your immediate spending power more than a traditional 401(k) plan. That matters if your budget is tight.

Since it's difficult to predict what tax rates will be decades from now, many financial advisors suggest putting money into both Roth and traditional 401(k) accounts.

401(k) vs. Brokerage Account

Brokerage and 401(k) accounts are both investment accounts, but they serve different purposes. A 401(k) is primarily for retirement savings, while a brokerage account can be used for various financial goals and offers more control over the investments.

A 401(k) is a type of qualified retirement plan. Within it, you can choose from a menu of investment options (generally mutual funds) where your money grows in a tax-advantaged manner.

A brokerage account, meanwhile, is a private account where you can buy, sell, and hold whatever securities your broker has access to, including mutual funds, stocks, bonds, and exchange-traded funds (ETFs). Brokerage accounts are taxable, meaning that your capital gains and dividends are subject to tax in the current period. There are also no contribution limits, early withdrawal considerations, or minimum distributions.

Note that brokers may also offer individual retirement accounts (IRAs), which share certain features of both 401(k) and individual accounts. Like a 401(k), these retirement accounts grow tax-deferred and have annual contribution limits that are lower than those of a 401(k). They also require RMDs at age 72. But like a brokerage account, they are not employer-sponsored, and you can invest in a range of securities such as stocks, bonds, and ETFs.

401(k) vs. Brokerage Account

401(k)

  • Retirement account

  • Employer-sponsored

  • Limited menu of investment options

  • Tax-deferred

  • Annual contribution limits

  • Early withdrawal penalties

  • RMDs

  • Potential for employee matching

Brokerage Account

  • Can be used for anything

  • Self-sponsored

  • Can buy or sell any investment

  • Taxable

  • No contribution limits

  • No withdrawal penalties

  • No RMDs

  • No matching

What Happens to Your 401(k) When You Leave a Job

When you leave a company where you've been employed and you have a 401(k) plan, you generally have four options:

1. Withdraw the Money

Withdrawing the money is usually a bad idea unless you urgently need it. The money will be taxable for the year it's withdrawn. You will be hit with the additional 10% early distribution tax unless you are over 59½, permanently disabled, or meet the other IRS criteria for an exemption from the rule.3423

For a Roth 401(k), you can withdraw your contributions (but not any profits) tax-free and without penalty at any time if you have had the account for at least five years.17 However, you're still decreasing your retirement savings, which you may regret later.

2. Roll Your 401(k) Into an IRA

Moving the money into an IRA at a brokerage firm, a mutual fund company, or a bank means avoiding immediate taxes and maintaining the account's tax-advantaged status. What's more, you can choose from among a wider range of investment choices than with your employer's plan.34

The IRS has relatively strict rules on rollovers and how they need to be accomplished. Running afoul of them is costly.35 Typically, the financial institution in line to receive the money will help with the process to prevent any missteps.

Funds withdrawn from your 401(k) must be rolled over to another retirement account within 60 days to avoid taxes and penalties.35

3. Leave Your 401(k) With the Former Employer

In many cases, employers permit a departing employee to keep a 401(k) account indefinitely in their old plan, though the employee can't contribute further. This generally applies to accounts worth at least $5,000. For smaller accounts, the employer may give the employee no choice but to move the money elsewhere.34

Leaving the money where it is makes sense if the former employer's plan is well-managed and you are satisfied with its investment choices. The danger is that employees who change jobs throughout their careers can leave a trail of old 401(k) plans and may forget about one or more of them. Their heirs might also be unaware of the existence of the accounts.

Capitalize, an investment platform specializing in rolling over forgotten or left-behind 401(k) accounts, estimates that in 2023, there were almost 30 million such accounts in the U.S., holding about a quarter of Americans' total assets in 401(k) plans.36

4. Move Your 401(k) to a New Employer

You can usually move your 401(k) balance to your new employer's plan.34 As with an IRA rollover, this maintains the account's tax-deferred status and avoids immediate taxes.

If you aren't comfortable with managing a rollover IRA, you can leave some of the work to the new plan's administrator.

What Is the Maximum Contribution to a 401(k)?

For most people, the maximum contribution to a 401(k) plan is $23,000 in 2024. If you are more than 50 years old, you can make an additional catch-up contribution of $7,500 for both years. There are also limitations on the employer's matching contribution: The combined employer-employee contributions cannot exceed $69,000 in 2024 (or $76,500 for employees over 50 years old).2037

Is It a Good Idea to Take Early Withdrawals From Your 401(k)?

There are few advantages to taking an early withdrawal from a 401(k) plan. If you withdraw before 59½, you will face a 10% penalty in addition to any taxes you owe. However, some employers allow hardship withdrawals for sudden financial needs, such as medical costs, funeral costs, or buying a home.38 This can help you avoid the early withdrawal penalty, but you will still have to pay taxes.

What Is the Main Benefit of a 401(k)?

A 401(k) plan lets you reduce your tax burden while saving for retirement. Not only do you get tax-deferred gains, it's also hassle-free since contributions are automatically subtracted from your paycheck. Many employers will match part of their employee's 401(k) contributions, effectively giving them a free boost to their retirement savings.

The Bottom Line

A 401(k) plan is a workplace retirement plan that allows you to make annual contributions up to a specific limit and invest that money for your later years after your working days are over.

There are two types of 401(k) plans: traditional or Roth. The traditional 401(k) involves pretax contributions that give you a tax break when you make them and reduce your taxable income. However, you pay ordinary income tax on your withdrawals. The Roth 401(k) involves after-tax contributions and no upfront tax break, but you won't pay taxes on your withdrawals in retirement. Both accounts allow employer contributions that can increase your savings.

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