What Is a 401(k)? How 401(k) Plans Work

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A 401(k) is a retirement savings plan offered by an employer that lets workers put part of each paycheck into an investment account with tax advantages. The name comes from subsection (k) of Section 401 of the U.S. Internal Revenue Code, the provision that allows these salary deferrals. Money goes in through payroll, is invested in funds the plan offers, and grows without yearly taxes on gains. Withdrawals are limited until retirement age, with penalties and required distributions setting the rules at either end.

The central choice is how the money is taxed. A traditional 401(k) takes contributions before income tax and taxes withdrawals later. A Roth 401(k) takes contributions after income tax and lets qualified withdrawals come out tax-free. Many employers also add their own money through a match, which is often the largest immediate benefit of joining the plan.

What is a 401(k)?

A 401(k) is a qualified, employer-sponsored retirement plan. “Qualified” means it meets federal tax-code requirements that give it special tax treatment, and in the private sector it is also governed by ERISA, the federal law that sets standards for workplace benefit plans. The employer sets up the plan, picks a provider to run it, chooses the investment menu and decides features such as matching, vesting and loans. The employee decides whether to participate, how much to contribute and how to invest.

The “k” has no meaning beyond its place in the tax code. Section 401 covers qualified retirement plans, and subsection (k) describes the cash or deferred arrangement that lets employees choose between taking pay as cash or deferring it into the plan.

Defined contribution vs. defined benefit

What is defined is the money going in: your deferrals and any employer contributions. What you have at retirement is whatever that money has grown (or shrunk) to. You bear the investment risk and decide how to draw the balance down.

A traditional pension is a defined benefit plan. The employer promises a specific payment for life, usually based on salary and years of service, and carries the investment risk of funding that promise. Calling a 401(k) a “pension” uses the word loosely. In exchange for putting the risk on you, a 401(k) is portable: the vested balance goes with you when you leave, while pension benefits often depend on long tenure with one employer. Some employers offer both.

Who can have one

You generally get a 401(k) through an employer that sponsors one. Plans set their own eligibility rules within federal limits, such as a minimum age or a waiting period after hiring. Self-employed people and business owners with no employees other than a spouse can open a solo 401(k) (also called a one-participant or independent 401(k)) through a brokerage, which lets them contribute both as the “employee” and as the “employer.” Federal civilian employees and service members have a similar plan of their own, the Thrift Savings Plan.

How a 401(k) works

When you enroll, you elect a contribution, usually a percentage of each paycheck. Your employer withholds that amount and sends it to your account at the plan’s recordkeeper. Because the deduction happens before you see the money, saving is automatic and continues until you change your election.

Some plans enroll employees automatically at a set percentage unless they opt out, and some raise that percentage a little each year. Under the SECURE 2.0 Act of 2022, most new 401(k) plans established after that law’s enactment must include automatic enrollment starting with the 2025 plan year, with exceptions for small and new businesses. Older plans may or may not use it.

What’s inside a 401(k)

A 401(k) is an account, not an investment. The money inside is invested in options the plan offers, which commonly include:

• Target-date funds, which hold a mix of stocks, bonds and other securities and shift gradually toward more conservative holdings as a chosen retirement year approaches
• Stock mutual funds and index funds, covering U.S., international, large-company or small-company shares
• Bond funds, which tend to fluctuate less than stock funds
• Stable value funds or guaranteed investment contracts, issued by insurance companies and designed to protect principal
• Employer stock, offered by some companies

You can usually change how future contributions are invested and move existing balances between funds. If you never make a choice, the plan puts your money in its default investment, frequently a target-date fund.

Fees

Plans have costs: fund expense ratios, recordkeeping and administrative charges, and sometimes fees for specific services such as loans. These come out of your account balance or your fund returns. Plans are required to disclose fees to participants, and the numbers matter because a cost deducted every year compounds the same way returns do.

How to start a 401(k)

1. Ask your employer (often the HR or benefits department) whether a plan exists, when you become eligible and whether there is a match.
2. Enroll through the plan provider’s website or the paperwork your employer gives you, or confirm the details if you were enrolled automatically.
3. Pick a contribution rate. If there is a match, the rate that captures the full match is a natural first target.
4. Choose traditional, Roth or both, if the plan offers a Roth option.
5. Select investments, or confirm that the default fund suits you.
6. Name a beneficiary, the person who receives the account if you die. The beneficiary designation generally controls over a will.

Traditional vs. Roth 401(k)

Both versions share the same contribution limit, the same investment menu and the same employer. The difference is when the tax is paid.

Traditional 401(k)

Traditional contributions come out of your pay before federal income tax is calculated, so they reduce your taxable income for the year. If you earn $70,000 and defer $7,000, your wages for federal income tax purposes are $63,000. The deferral does not avoid Social Security and Medicare taxes, which still apply to the full $70,000.

Inside the account, contributions and earnings grow without being taxed each year. When you withdraw, every dollar comes out as ordinary income, taxed at your rate in the year of the withdrawal.

Roth 401(k)

Roth 401(k) contributions come from pay that has already been taxed, so they do not lower your current tax bill. In return, qualified distributions, including all the investment growth, are tax-free. A distribution is qualified when the Roth account has been held for at least five tax years and you are at least 59½, disabled, or the distribution goes to a beneficiary after your death.

Employers are not required to offer a Roth 401(k), which became available in 2006, so check whether your plan does.

Because a Roth contribution is made with after-tax money, contributing the same percentage of pay to a Roth costs you more take-home pay today than a traditional contribution would. That can matter on a tight budget.

How to think about the choice

The decision comes down to whether your tax rate is likely to be higher now or when you withdraw. A hypothetical example shows why.

Hypothetical: You have $1,000 of pretax pay to save, your marginal tax rate is 22% now and in retirement, and the investment quadruples before you withdraw.

• Traditional: All $1,000 goes in. It grows to $4,000. Withdrawal is taxed at 22%, leaving $3,120.
• Roth: You pay $220 in tax first, so $780 goes in. It grows to $3,120. Withdrawal is tax-free, leaving $3,120.

With equal tax rates, the result is identical. The Roth wins if your rate in retirement turns out higher than today, and the traditional account wins if it turns out lower. People early in their careers often expect higher future income and lean Roth; people in their peak earning years often value the immediate deduction. Because nobody knows future tax law, some savers hedge by splitting contributions between the two, in any proportion as long as the total stays within the annual limit.

Employer matching contributions have traditionally gone into the pretax side. SECURE 2.0 allows plans to let employees receive matching contributions as Roth contributions, which are then taxable in the year they are made; whether that option exists depends on the plan.

401(k) contribution limits

The IRS caps how much can go into a 401(k) each year and adjusts the caps periodically for inflation. There are two separate limits: one for your own salary deferrals and one for total contributions from all sources.

Employee deferral limits (traditional and Roth combined):

• 2025: $23,500 for workers under 50. Workers 50 and older could add a $7,500 catch-up contribution, for $31,000 in total.
• 2026: $24,500 for workers under 50. Workers 50 and older can add an $8,000 catch-up, for $32,500 in total.
• Ages 60 to 63: a higher catch-up of $11,250 applies, allowing up to $35,750 in 2026.

Combined employee and employer limits:

• 2025: $70,000, or $77,500 including the age-50 catch-up.
• 2026: $72,000, or $80,000 including the age-50 catch-up.

The employee limit applies per person across all your 401(k) and 403(b) plans. If you switch jobs mid-year, deferrals at both employers count toward one $24,500 cap (for 2026), so you need to track the total yourself. The combined limit applies per employer plan, and it is where employer matches, profit-sharing contributions and any after-tax contributions are counted.

Employer matching and vesting

An employer match is money the company adds to your account based on what you contribute. Plans set their own formulas. Two common structures:

• Partial match: the employer adds $0.50 for each $1 you contribute, up to a set percentage of salary, such as 6%.
• Dollar-for-dollar match: the employer matches 100% of your contributions up to a set percentage, such as 3% or 4%.

Under a 50% match on the first 6% of pay, contributing 6% earns a match worth 3% of salary. Contributing only 3% earns 1.5%, and contributing 10% still earns only 3%, because the match stops at the 6% ceiling. Contributing less than the amount needed to receive the full match leaves part of your compensation unclaimed. Some employers also make nonelective or profit-sharing contributions that do not depend on whether you contribute at all.

Vesting

Your own contributions are always 100% yours. Employer contributions may come with a vesting schedule, which determines how much of that money you keep if you leave.

• Cliff vesting: you own none of the employer money until a set point (no later than three years of service for matching contributions), then all of it.
• Graded vesting: ownership rises in steps, for example 20% per year, reaching 100% no later than six years of service for matching contributions.

If you leave before you are fully vested, the unvested portion is forfeited, which can affect the timing of a job change.

How your 401(k) earns money

A 401(k) grows from your contributions, your employer’s contributions and investment returns: rising share prices, dividends and bond interest. All of it stays in the account untaxed until withdrawal (or permanently, for qualified Roth money).

Because earnings stay invested, they produce earnings of their own. This is compounding, and over long periods it can account for more of the final balance than the contributions themselves. Tax deferral strengthens the effect: in a taxable account, part of each year’s dividends and realized gains would go to taxes instead of being reinvested.

Investment returns are not guaranteed. Stock funds can lose value, sometimes sharply, and the balance on any given day reflects current market prices.

Example of a 401(k)

The following is a hypothetical example to show the mechanics. It is not a projection or a typical outcome.

Assumptions: Maria earns $60,000 a year. She contributes 6% of salary to a traditional 401(k). Her employer matches 50% of contributions up to 6% of salary. Her marginal federal income tax rate is 22%. Her salary stays flat, the account earns 6% a year after fees, and contributions are treated as made at the end of each year.

Each year’s contributions:

• Maria’s deferral: 6% × $60,000 = $3,600
• Employer match: 50% × $3,600 = $1,800
• Total going into the account: $5,400

Effect on her paycheck: Her taxable wages drop from $60,000 to $56,400. At a 22% marginal rate, that lowers her federal income tax by about $3,600 × 0.22 = $792. So putting $3,600 into the plan reduces her take-home pay by roughly $2,808 (before state tax effects), while $5,400 lands in her account.

Growth over 30 years: The future value of equal yearly deposits uses the annuity formula:

FV = P × [(1 + r)^n − 1] / r

With P = $5,400, r = 0.06 and n = 30:

• 1.06^30 ≈ 5.7435
• (5.7435 − 1) / 0.06 ≈ 79.06
• $5,400 × 79.06 ≈ $426,900

Total deposits over 30 years are $162,000 ($108,000 from Maria and $54,000 from the employer). The remaining roughly $265,000 is investment growth. Because this is a traditional account, withdrawals will be taxed as ordinary income in retirement, so the after-tax value depends on her tax rate then.

Changing any assumption changes the result. A lower return, higher fees, missed years or a smaller match would shrink the total; raises and higher contribution rates would increase it. In real markets, returns arrive unevenly, with losing years mixed in.

401(k) withdrawals

A 401(k) is built for retirement, and the rules make early access costly, which is why emergency savings belong in a separate, accessible account.

Age 59½ and the 10% additional tax

Once you reach 59½, you can take distributions from a traditional 401(k) without penalty (subject to plan rules), paying ordinary income tax on what you withdraw. Before 59½, distributions are generally subject to a 10% additional tax on top of income tax.

Hypothetical: At age 40, you withdraw $10,000 from a traditional 401(k). In a 22% federal bracket, you owe $2,200 in income tax plus a $1,000 additional tax, leaving $6,800 before any state income tax. You also lose the future growth that $10,000 would have earned.

The IRS lists exceptions to the 10% tax, including:

• Total and permanent disability
• Distributions to a beneficiary after the account owner’s death
• Separating from your employer in or after the year you turn 55 (the “rule of 55”), for money in that employer’s plan
• Unreimbursed medical expenses above a threshold tied to your income
• Payments under a qualified domestic relations order in a divorce
• A series of substantially equal periodic payments

Income tax still applies to traditional money in every case; the exceptions only remove the extra 10%.

Roth 401(k) withdrawals

A qualified Roth distribution is entirely tax-free. A nonqualified one is split proportionally between contributions (already taxed, so not taxed again) and earnings (taxable and potentially subject to the 10% additional tax). You cannot simply pull out contributions first, as you can with a Roth IRA.

Hardship withdrawals

Many plans allow hardship distributions for an immediate and heavy financial need, using categories the IRS recognizes, such as certain medical costs, funeral expenses, costs related to buying a principal residence, tuition, and payments to prevent eviction or foreclosure. A hardship distribution lets you reach the money while still working, but it does not remove taxes: the amount is taxable income, and the 10% additional tax still applies unless a separate exception covers you. Hardship withdrawals also cannot be repaid to the plan.

401(k) loans

Some plans let you borrow from your own balance. The general federal limit is the lesser of $50,000 or 50% of your vested balance (with a $10,000 option for small balances). Repayments, including interest, go back into your own account, typically through payroll over up to five years, longer for a home purchase.

A loan avoids taxes and penalties as long as it is repaid on schedule. The risks: the borrowed money is out of the market while it is lent to you, and if you leave your job, the plan may require the outstanding balance to be repaid by a deadline. An unpaid balance is treated as a distribution, which makes it taxable and possibly subject to the 10% additional tax.

Required minimum distributions

Starting at age 73, owners of traditional 401(k) accounts must take required minimum distributions (RMDs) each year. The amount is calculated by dividing the account balance at the end of the prior year by a life expectancy factor from IRS tables. Missing an RMD triggers an excise tax on the amount you should have withdrawn.

The RMD age has moved several times. It was 70½ for decades, rose to 72 under the SECURE Act of 2019 (effective 2020), and rose to 73 under the SECURE 2.0 Act of 2022.

Two details narrow the rule:

• Still working: if you are still employed by the company sponsoring the plan and do not own more than 5% of the business, the plan may let you delay RMDs from that plan until you retire.
• Roth 401(k): beginning in 2024, designated Roth accounts in workplace plans are no longer subject to RMDs during the owner’s lifetime.

What happens to your 401(k) when you leave a job

Your vested balance stays yours when you change jobs. You generally have four options.

1. Cash out

You can take the money as a distribution. Traditional money is taxable in the year you receive it, and the 10% additional tax applies if you are under 59½ and no exception fits. The plan is also required to withhold 20% for federal income tax when it pays an eligible rollover distribution directly to you. Cashing out also removes the money from your retirement savings permanently.

2. Roll it into an IRA

A rollover to an individual retirement account at a brokerage or bank keeps the money tax-advantaged and usually opens up a much wider range of investments than a plan menu. Traditional money goes into a traditional IRA and Roth money into a Roth IRA.

The safest method is a direct rollover, in which the old plan sends the money straight to the new account, with no withholding. In an indirect rollover, the plan pays you, withholds 20%, and you have 60 days to deposit the full amount into the new account. To roll over the entire balance, you must make up the withheld 20% from other funds; whatever you do not deposit within 60 days is treated as a taxable distribution.

3. Leave it in your former employer’s plan

Many plans let a departing employee keep the account where it is, without making new contributions, if the balance is above a threshold: $5,000, or $7,000 for plans that adopt the higher limit set by SECURE 2.0. Smaller balances can be moved out automatically, often into an IRA.

Staying can make sense if the plan has low fees and investments you like, and it preserves access to the rule of 55 if you left in or after the year you turned 55. The drawback is accumulation: after several job changes, old accounts are easy to lose track of, and heirs may not know they exist. By one 2024 estimate, about 31.9 million forgotten or left-behind 401(k) accounts in the U.S. held roughly $2.1 trillion.

4. Move it to your new employer’s plan

If the new employer’s plan accepts rollovers, you can move the old balance into it. This keeps everything in one account, preserves the tax status and lets you use the new plan’s loan feature (if offered) on the combined balance. The new plan’s administrator usually handles much of the process.

401(k) vs. other accounts

401(k) vs. IRA

Both are tax-advantaged retirement accounts with traditional and Roth versions, but an IRA belongs to you rather than to an employer plan.

• Who opens it: an employer sponsors a 401(k); anyone with earned income can open an IRA.
• Limits: 2026 limits are $24,500 for 401(k) deferrals versus $7,500 for IRAs.
• Employer money: only a 401(k) can receive a match.
• Investments: a 401(k) offers a fixed menu; an IRA at a brokerage can hold most stocks, bonds and funds.
• Eligibility rules: Roth IRA contributions phase out at higher incomes, and the deductibility of traditional IRA contributions can be limited if you have a workplace plan. Roth 401(k) contributions have no income limit.

You can have both and contribute to each in the same year, within their separate limits.

401(k) vs. brokerage account

A taxable brokerage account is a general investment account with no contribution limits and no restrictions on withdrawals, holding whatever the broker offers. In exchange, there is no tax deferral and no employer match.

401(k) vs. 403(b), 457(b) and the TSP

These are close relatives. A 403(b) serves public schools, colleges, hospitals and other nonprofits; a 457(b) serves many state and local governments; the TSP serves federal workers. They share many features with 401(k)s, including deferral limits, but differ in details. Governmental 457(b) plans, for example, do not apply the 10% additional tax to distributions after you leave the employer.

History of the 401(k)

Section 401(k) entered the tax code through the Revenue Act of 1978, effective 1980, originally to address deferred compensation arrangements, largely for executives. After benefits consultants saw it could let ordinary employees defer pay into a savings plan, and the IRS issued guidance in 1981 permitting salary deferrals, employers began offering 401(k) plans widely.

Many companies first offered 401(k)s as a supplement to pensions. Over the following decades, employers shifted away from defined benefit pensions, moving the responsibility and risk of retirement saving to employees. Today the 401(k) is the most common retirement plan sponsored by private employers in the U.S.

Later laws reshaped it. The Pension Protection Act of 2006 made automatic enrollment easier for employers to adopt, and the SECURE Act of 2019 and SECURE 2.0 Act of 2022 brought the changes to RMDs, catch-up contributions and automatic enrollment described above.

How a stock sell-off affects your 401(k)

When stock prices fall, so does the value of any stock funds in your 401(k). Target-date funds fall too, though usually less for someone near the target year, because those funds hold more bonds by then.

A decline on your statement is a change in market value, not a realized loss. Selling the falling investments locks in the loss, and the money then misses any later recovery. Meanwhile, ongoing payroll contributions buy more fund shares per dollar during a decline. Time horizon shapes the risk: someone decades from retirement has years of contributions ahead, while someone about to start withdrawals may be forced to sell at low prices. That is why a stock-heavy mix usually becomes more conservative near retirement.

FAQs

The Bottom Line

A 401(k) matters most to workers whose employer offers one, especially when the plan includes a match. Contributing at least enough to collect the full match, choosing traditional or Roth based on expected tax rates, and avoiding withdrawals before 59½ keep more of the account working toward retirement. When changing jobs, a direct rollover to an IRA or a new employer's plan avoids withholding and keeps the savings tax-advantaged.