What is a 401(k)?
– A 401(k) is a tax-advantaged, employer-sponsored retirement savings plan defined by the U.S. tax code. It is a defined-contribution plan: the employee’s account balance depends on the amounts contributed plus investment gains or losses, not on a promised monthly benefit.
How 401(k)s work (big-picture)
– You elect to have a portion of each paycheck placed into a 401(k) account. Employers often offer to match part of your contribution.
– The employer provides a menu of investment choices (for example, stock and bond mutual funds or target-date funds). You pick where your contributions are invested from that menu.
– Contributions and earnings grow tax-deferred in a traditional 401(k); withdrawals are taxed later. With a Roth 401(k), contributions are made with after-tax dollars and qualified withdrawals are tax-free.
Key definitions
– Pretax contributions: Money deposited before income taxes are applied; lowers taxable income today (typical of traditional 401(k)).
– After-tax (Roth) contributions: Money deposited after income taxes; no tax deduction now but qualified withdrawals are tax-free.
– Catch-up contribution: An additional contribution permitted for participants age 50 and over.
– Employer match: Extra contributions an employer makes based on how much you contribute (may be mandatory for some plans).
Types of 401(k)
– Traditional 401(k): Contributions reduce taxable income today; withdrawals in retirement are taxed as ordinary income.
– Roth 401(k): Contributions do not reduce current taxable income; qualified withdrawals in retirement are tax-free. Roth contributions reduce your take-home pay more than equivalent pretax contributions because no immediate tax break applies.
Contribution limits (2025)
– Under age 50: employee contribution limit = $23,500.
– Age 50 and over: total employee limit with catch-up = $31,000 (that is $23,500 + $7,500 catch-up).
– Employers may also contribute; combined employer + employee limits can differ and are adjusted periodically for inflation.
How your 401(k) can grow
– Growth comes from investment returns on the funds you select (capital appreciation, dividends, interest). Typical plan options include stock and bond funds and target-date funds that become more conservative as retirement approaches.
Starting a 401(k): practical checklist
1. Confirm eligibility and enrollment periods with HR.
2. Choose traditional vs. Roth (based on current vs. expected future tax rates).
3. Set a contribution percentage of each paycheck. At minimum, contribute enough to receive the full employer match.
4. Select investments from the employer’s menu (consider target-date funds if you want a set-and-forget option).
5. Check for employer match details and any vesting schedule (when employer match fully belongs to you).
6. Review periodically and rebalance as needed.
Worked numeric example (simple)
– Salary: $60,000 per year. You elect to contribute 8% to your 401(k).
– Your annual contribution = 60,000 × 8% = $4,800.
– Employer match: 50% of your contributions up to 6% of salary. Employer pays 3% of salary = 60,000 × 3% = $1,800.
– Total annual contribution (you + employer) = $4,800 + $1,800 = $6,600.
– If this is a traditional 401(k), your taxable income this year would be reduced by $4,800. If it is a Roth, there’s no current tax reduction.
Withdrawals and rules
– Withdrawals from traditional 401(k)s are taxed as ordinary income. Roth 401(k) qualified withdrawals are tax-free.
– Withdrawals before age 59½ generally have tax consequences and may incur penalties. Always consult a tax professional before early withdrawal.
– Required Minimum Distributions (RMDs) may apply to some 401(k) accounts at specified ages—check current IRS rules.
What happens if you leave a job (common options)
1. Withdraw the money — may trigger taxes and penalties.
2. Roll the 401(k) into an IRA — a common way to preserve tax advantages and expand investment choices.
3. Leave the 401(k) with your former employer — allowed in many plans (plan rules vary).
4. Move the 401(k) to your new employer’s plan (if the new plan accepts rollovers).
– Before choosing, verify fees, investment options, and tax consequences.
Pros and cons (summary)
Pros
– Tax advantages (either now or later).
– Employer matching contributions can be “free” money toward retirement.
– Automatic payroll deductions encourage disciplined saving.
– Employer plans often offer low-cost funds and professionally managed target-date options.
Cons
– Limited investment choices compared with retail brokerage accounts.
– Early withdrawals can be costly (taxes + penalties).
– Roth contributions reduce take-home pay immediately.
– Plan rules—eligibility, vesting, and fees—vary by employer.
Short FAQ (brief)
– What is the maximum contribution? See the current annual IRS limits (2025: $23,500 under 50; $31,000 with catch-up for 50+).
– Should I take early withdrawals? Generally not—taxes and penalties often apply; consult a tax advisor.
– What if the market drops? Your account value will fall with investment markets; long-term investors may recover over time, but outcomes are not guaranteed.
Sources (for further reading)
– Investopedia — “401(k) Plan” (overview): https://www.investopedia.com/terms/1/401kplan.asp
– Internal Revenue Service (IRS) — 401(k) and profit-sharing plan contribution limits: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits
– U.S. Department of Labor — 401(k) plan fact sheet: https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/resource-center/publications/401k-plan-fact-sheet
– Fidelity — What is a 401(k)?: https://www.fidelity.com/retirement-ira/401k/what-is-401k
Educational disclaimer
This explainer is educational only and not personalized investment advice. For guidance specific to your situation, consult a qualified tax professional or financial advisor.