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

If building a retirement nest egg is your goal, contributing to a 401(k) if you have access to one could help you achieve it. These popular retirement savings plans are typically employer-sponsored, meaning that companies offer them as a benefit for employees. Regularly contributing to a 401(k) starting at a young age could help you build sizable savings by the time you retire.

Here’s what to know about 401(k) plans, how they work, what happens to them if you leave a job, and some additional retirement savings vehicles to consider.

How does a 401(k) work?

A 401(k) is a type of employer-sponsored retirement savings account that is administered through a financial services company like Empower or Fidelity Investments. These tax-advantaged retirement savings plans are subject to contribution limits and withdrawal rules. Generally, you can’t take money out of a 401(k) before age 59½ or you’ll incur a 10% penalty on the amount withdrawn, which will also be taxed as ordinary income. That said, there are a few exceptions to the 10% early withdrawal penalty.

If you opt to contribute to a 401(k), your elected contribution amount will be deducted from your paycheck and added to your account. Contributions to a 401(k) are often, but not always, pretax, meaning the money you add to your account doesn’t have taxes taken out of it. Your total contributions in a given year will reduce your taxable income.

For example, if you put $10,000 in annual pretax contributions into your 401(k) your gross income would be reduced by that amount.

Companies often offer matching contributions to employees who contribute to their 401(k)s, but these may not immediately become available. Employers sometimes have a vesting period: For instance, employer contributions may not be 100% vested until your third year of employment. That said, some companies offer vesting immediately. (See more on this below.)

History of the 401(k)

The 401(k) traces its roots back to 1978 when the U.S. Congress enacted The Revenue Act. This Act changed the U.S. tax code, with section 401 enabling elective deferrals to modern 401(k) and Flexible Spending Accounts (FSAs) for employees.

While the Revenue Act paved the way for 401(k)s, they didn’t officially become a retirement savings vehicle until 1980. Consulting company owner Ted Benna was the first person to conceptualize and introduce a 401(k) plan for his employees. He also advocated for widespread adoption of this type of plan. Today, 401(k) accounts are one of the most popular retirement savings available.

What is employer matching?

Employer matching is when a company matches a portion of your 401(k) contributions. It’s common to see company matches between 3% and 6% of your contributions, but individual employers set their own rules around matching. It’s possible to see a lower or higher percentage match.

Matches can also be dollar-for-dollar, 50 cents on the dollar, and more, up to a certain percentage of your contributions. Again, how an employer match is structured depends on the company. Here’s an example of how an employer match might work.

Let’s say you have an annual salary of $100,000 and your employer offers a generous dollar-for-dollar 6% 401(k) contribution match. If you contribute $6,000, or 6% of your salary, your employer match means your company will also contribute $6,000, for a total of $12,000.

The matched portion of your 401(k) is tax-deductible for your employer. It can’t be deducted from your taxable income the way the contribution that you make is deductible.

Types of 401(k) plans

A few different types of 401(k) plans exist, and early withdrawal penalties apply (in most cases) if you take money out before age 59½. Here are some common options:

Traditional 401(k)

With a traditional 401(k), arguably the most common employer-sponsored option, employees make pretax contributions to their retirement savings. This results in lower taxable income for a given year. Money withdrawn from a traditional 401(k) is taxable income—whether you take that out at retirement or sooner. (There are, however, special dispensations for qualified charitable distributions.) Required minimum distributions (RMDs) apply, so you’ll need to begin drawing down on your account at age 73. More on this below.

Roth 401(k)

Roth 401(k)s work differently. Contributions are post-tax, meaning taxes are already taken out of the money you add to your account. i Distributions from a Roth 401(k) aren’t taxed in retirement, and as of 2024, these accounts aren’t subject to RMDs. What’s more, there is no penalty for withdrawing your contributions (not their earnings, however) at any time and any age.

Solo 401(k)

A solo 401(k), also called an individual 401(k), is a plan for business owners with no other employees. Since the employer also acts as the employee in this case, contribution limits work a bit differently than with other 401(k) plans.

Per the IRS, you can contribute up to the max of $23,000 in elective deferrals, then up to an additional 25% of your earnings in non-elective deferrals. Total contributions can’t exceed $69,000 annually for 2024, though. Those age 50 or older can make an additional $7,500 in catch-up contributions.

How does your 401(k) earn money?

Your 401(k) contributions are invested into a set of funds that your employer has selected. When the stock market is high and those funds perform well, you’ll realize investment gains. But your 401(k) balance can also decrease if the market declines.

Market fluctuations are a risk with any type of investment. That said, contributing to a 401(k) is still one of the best ways to build a retirement nest egg over the long term.

Required minimum distributions

Once you reach age 73, you’ll need to begin taking required minimum distributions, or RMDs, from your 401(k) account. If you have a traditional 401(k), your RMDs will be taxed at your ordinary income tax rate. To determine your RMDs, the IRS considers your total retirement account balance and your life expectancy.

While RMDs used to be required for Roth 401(k)s, that’s no longer the case as of 2024. Withdrawals from a Roth account made after 59½ aren’t subject to income taxes, provided that your account has been open more than five years.

401(k) contributions

As mentioned, contribution limits apply for 401(k)s. Here’s a look at the limits and how much it makes sense to contribute.

How much can I contribute to my 401(k)?

For 2024, you can make $23,000 worth of contributions to your 401(k) if you’re under age 50. Employees 50 and older can make additional contributions of $7,500, for a total of $30,500 per year. The IRS revisits contribution limits annually, so they may increase for 2025 and beyond.

How much should I contribute to my 401(k)?

It’s smart to contribute enough to your 401(k) to maximize your employer match, if available. But in general, making contributions totaling 10% to 15% of your annual pretax income could set you on a good path toward retirement. If you’re just starting out, try to contribute as much as you can afford and work toward a higher percentage over time.

When can I withdraw from my 401(k)?

Contributions to a 401(k) are also generally subject to a 10% early withdrawal penalty if you take money out before you turn 59½. There are some exceptions where you won’t incur a withdrawal penalty, though, including withdrawals of up to $5,000 for birth or adoption expenses and withdrawals in the event of total or permanent disability. And starting in Jan. 2024, a new IRS provision allows “an emergency personal expense distribution in any calendar year” of “a maximum of $1,000” without penalty.

The IRS provides detailed information about potential exceptions to the 10% penalty. In general, tapping into your 401(k) balance should be considered a last resort if you’re having financial difficulty. Doing so could set your retirement savings off track.

What happens to my 401(k) if I leave my job?

If you leave your job, in most cases you can leave your balance in your existing 401(k) or roll it over to a new retirement account, such as an IRA or an employer-sponsored plan at a new employer (if the plan permits this). Initiating a “direct transfer” can help you avoid withdrawing your money with a check to you instead of a new retirement-plan trustee, which can lead to incurring income taxes and an IRS penalty.

Just be mindful if your 401(k) contributions were pretax or post-tax before you roll money over. If you made pretax contributions, rolling funds over into a traditional IRA could be the least complicated approach from a tax perspective. (Post-tax money can go to a Roth IRA.) Consulting with an investment advisor can help you determine the best rollover option for you.

Alternatives to a 401(k)

401(k) vs. IRA

The biggest difference between a 401(k) versus an IRA is that a 401(k) is an employer-sponsored retirement savings plan, while an IRA is an individual retirement savings account that you open. Many financial services companies allow you to open an IRA. For instance, you could opt for a Robinhood IRA, Fidelity IRA, and more. Both 401k(s) and IRAs have different contribution limits and rules. Another huge difference: the amount you are allowed to contribute.

Here’s how they compare:

401(k) vs. brokerage account

Taxable brokerage accounts aren’t subject to contribution limits like a 401(k). Employers choose the investment options in a 401(k), but taxable brokerage accounts aren’t employer-sponsored. You’ll have a much broader investment selection with a taxable brokerage account.

On the other hand, your traditional 401(k) contributions aren’t taxed until you begin making withdrawals in retirement. Investments sold through a brokerage account are subject to capital gains taxes. Your capital gains tax rate will depend upon your tax bracket and how long you held the investment before the sale. You may also owe taxes on dividends paid through a brokerage account that wouldn’t be owed if they were in a 401(k).

TIME Stamp: 401(k)s are one of the best ways to save for retirement

Putting money aside in a 401(k), if you have access to one, is one of the best ways to save for retirement. This is especially true if your company offers contribution matching, which is essentially free money to help grow your retirement savings. That said, 401(k)s are subject to IRS rules around maximum contribution limits and early withdrawals. It’s important to familiarize yourself with these rules before you start contributing.

Frequently asked questions (FAQs)

What’s the average employer match?

It’s common for companies to match employee 401(k) contributions at a rate of 3% to 6%. Some employers might offer a dollar-for-dollar match, while others may only offer 50 cents on the dollar.

Can you have both a 401(k) and an IRA?

Yes, it’s possible to have both a 401(k) and an IRA. If your company offers contribution matching, it’s wise to prioritize contributing to a 401(k) to ensure you get that matching benefit. But you can have and contribute to both types of accounts.

At what age can you withdraw from a 401(k)?

You can withdraw money from a 401(k) without penalty once you reach age 59½, though the IRS does allow you early distributions to cover certain expenses and for emergencies, following specified rules. For instance, if you adopt a child, you can make a $5,000 early withdrawal from your 401(k) to pay for related expenses. Non-qualified 401(k) withdrawals are subject to a 10% penalty.