What Is a 401(k) and How Does It Work?
- Jennifer Wills
- Jun 25
- 4 min read
Updated: Jul 20

I had a few jobs in my 20s that offered a 401(k). Had I known how important contributions were, I would have made more to save for retirement.
What a 401(k) Is
A 401(k) is an employer-sponsored retirement plan that offers tax benefits. Employees invest money that can grow tax-free.
Each employee decides which percentage of their income to contribute to their 401(k). Then, the employer automatically withholds a portion of each paycheck and invests it into the account.
Traditional 401(k)
An employee with a traditional 401(k) has money taken out of each paycheck before federal income taxes are calculated, reducing their current tax liability. They pay ordinary income taxes on the pretax contributions and growth when withdrawing money during retirement. The employee must be older than 59 ½, or 55 if separated from their current employer, to avoid penalties on withdrawals.
Roth 401(k)
An employee with a Roth 401(k) has money taken out of each paycheck after federal income taxes are calculated. Their money can grow tax-free and be withdrawn without taxes during retirement. The employee avoids penalties and taxes on withdrawals if they hold the account for at least 5 years and are older than 59 ½, or age 55 if separated from their current employer.
401(k) Investment Funds
Typically, an employee can choose among 401(k) investment funds that fit their risk tolerance and time to retirement. Common options include:
Mutual funds
Exchange-traded funds
Target-date funds
Index funds
Money market funds
Stocks
Bonds
401(k) Employer Matching
An employer who offers a 401(k) match invests money into each participating employee’s account based on the money they put in. The match depends on the specifics of the employer’s plan. For instance, an employer might offer a dollar-for-dollar match up to a specific dollar amount. Or, they might base the match on a percentage of the employee’s contribution and a percentage of their wages.
To illustrate, say an employee earns $6,000 per month and their employer matches 50% of their 401(k) contributions up to 6% of their wages. To receive the full employer match, the employee would contribute at least $360 per month, which is 6% of their monthly wages. Their employer would put in an additional $180 per month, which is 50% of $360, to match their contribution. Therefore, $540 per month would be invested in the employee’s account.
401(k) Vesting
Vesting is the sum of money in an employee’s 401(k) that the employee would receive if they left the company or took a distribution:
Employee contributions are immediately vested and considered theirs.
Employer contributions typically are not vested until the employee remains with the company for a set time.
If the company has a vesting schedule, an employee might be unable to keep all the money the employer invested on their behalf if they leave before the set time.
The plan administrator can answer questions about the vesting requirements of a 401(k) plan.
401(k) Contribution Limits
The IRS sets annual contribution limits for 401(k) plans. The following are the contribution limits for 2025:
The employee elective deferral limit is $23,500.
Employees aged 50 or older are allowed catch-up contributions up to $7,500 for a total contribution of $31,000.
Employees aged 60 to 63 can make a catch-up contribution of $11,250 for a total elective deferral of $34,750.
An employer’s contributions do not count toward the annual elective deferral limit.
Contributions to a 401(k) must be made during the calendar year. Therefore, any additional money must be invested before the end of the year to boost the account and receive the special tax treatment.
Tips for Determining 401(k) Contributions
How much an employee contributes to their 401(k) depends on their retirement goals and desired savings amount. The following are age-based guidelines:
Employees starting in their 20s should save 10-15% of their salary annually.
Employees starting in their 30s should save 15-20% of their salary annually.
Employees starting in their 40s should save 25-35% of their salary annually.
Employees starting in their 50s or later should save as much as possible and consider other strategies for retirement.
Maximizing 401(k) Contributions
An employee who contributes up to the annual 401(k) contribution limits grows their investments tax-free until retirement. Therefore, employees should consider using any bonuses or raises to help fund their retirement goals.
401(k) Options When Changing Jobs
An employee who leaves their job has several options for handling their 401(k):
Withdraw the money (not recommended): Any withdrawals are taxable in the year they are withdrawn. A 10% early distribution tax will apply unless the employee is 59 ½ or older, permanently disabled, or meets the IRS criteria for an exemption. Contribution withdrawals from a Roth 401(k) are tax-free and without penalty if the employee has had the account for at least 5 years or meets the IRS criteria for exemption.
Leave the 401(k) with the former employer (risky): An employee who regularly changes jobs and leaves their retirement accounts with their former employers could forget about them.
Roll the 401(k) into an Individual Retirement Account: Moving the money into an Individual Retirement Account (IRA) within 60 days of withdrawal avoids immediate taxes and maintains the account’s tax-advantaged status.
Move the 401(k) to the new employer: Moving the retirement account balance to the new employer’s plan maintains its tax-deferred status.
401(k) Early Withdrawal
The results of taking money from a 401(k) account before age 59 ½ typically include paying taxes on the pretax contributions and any growth, plus a 10% penalty. The exceptions that do not require paying a 10% penalty include:
An employee who loses or leaves their job at age 55 or older and takes distributions from the 401(k) associated with their most recent job
Certain qualified birth or adoption expenses
A series of substantially equal payments
Permanent disability
401(k) Required Minimum Distributions
Generally, when an employee reaches age 73, or age 75 if born in 1960 or later, they must begin taking required minimum distributions (RMDs) from tax-deferred retirement accounts, including a 401(k). The RMD is calculated by taking the account balance on December 31st of the prior year and dividing it by the distribution period, a number the IRS assigns for each age.
For instance, a single 75-year-old who ended last year with $1 million in their 401(k) and has a distribution period of 24.6 would have an RMD of $40,650. ($1,000,000 ÷ 24.6)
*This information is for educational purposes only.
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