401(k) Explained
How employer-sponsored 401(k) plans work, including matching and contribution limits.
⏱️ ~8 min read
Key Takeaways
- A 401(k) is an employer-sponsored retirement account that allows contributions from pre-tax (traditional) or after-tax (Roth) income, depending on the plan and option chosen
- Many employers offer a 'match' — contributing additional money based on how much an employee contributes, up to a limit
- Contributions are subject to annual IRS limits, which are adjusted periodically and differ for those under and over age 50
- Withdrawals before age 59½ are generally subject to a penalty in addition to any taxes owed, with certain exceptions
What a 401(k) is
A 401(k) is a type of employer-sponsored retirement savings plan in the U.S., named after the section of the tax code that established it. Employees can contribute a portion of their salary to the plan, where it's invested (typically in a menu of mutual funds or similar options chosen by the employer's plan administrator) and grows on a tax-advantaged basis until withdrawal, generally in retirement.
Because contributions are typically made automatically through payroll deductions, 401(k)s are often cited as an example of the 'automation' principle discussed in Investing for Beginners — money is invested before it reaches a checking account, removing a manual decision point.
Traditional vs. Roth 401(k) contributions
Many (though not all) 401(k) plans offer both traditional and Roth contribution options. Traditional 401(k) contributions are made with pre-tax income — reducing taxable income in the year of contribution — but withdrawals in retirement are taxed as ordinary income. Roth 401(k) contributions are made with after-tax income — no immediate tax deduction — but qualified withdrawals in retirement are generally tax-free, including any investment growth.
This is the same fundamental trade-off discussed in the Roth vs. Traditional IRA lesson: pay taxes now (Roth) or pay taxes later (traditional), with the better choice depending on factors like current vs. expected future tax rates — a topic this Academy doesn't provide personalized advice on, given its dependence on individual circumstances.
Employer matching
Many employers offer a 'match' — contributing additional money to an employee's 401(k) based on the employee's own contributions, up to a certain limit. A common example structure is matching 50% or 100% of employee contributions up to a certain percentage of salary (the specific formula varies considerably by employer).
Example: How an employer match works
An employer offers a 100% match on the first 4% of salary an employee contributes. An employee earning $60,000 contributes 4% ($2,400) to their 401(k) over the year.
The employer would contribute an additional $2,400 (matching 100% of the employee's contribution, up to the 4% limit) — effectively doubling the employee's own contribution for that portion.
If the employee contributed only 2% ($1,200), the employer match (at 100% up to 4%) would also be $1,200 — matching what was contributed, since the employee didn't reach the full 4% needed to receive the maximum match. Employer matching contributions are sometimes described as 'free money' precisely because they represent additional retirement savings beyond what the employee directly set aside, though they're still part of the employee's overall compensation from the employer's perspective.
Contribution limits
The IRS sets annual limits on how much can be contributed to a 401(k) — both for employee contributions and for combined employee-plus-employer contributions. These limits are periodically adjusted (often annually) for inflation, and there's typically an additional 'catch-up' contribution limit for those age 50 and older, allowing higher contributions later in a career. Because these limits change over time, checking current figures from the IRS or a plan administrator is recommended rather than relying on a fixed number.
Withdrawals and early withdrawal penalties
401(k) funds are generally intended to remain invested until retirement. Withdrawals before age 59½ are generally subject to a 10% early withdrawal penalty (in addition to any income taxes owed on traditional 401(k) withdrawals), with certain exceptions defined by the IRS (such as specific hardship circumstances, though the exact rules are detailed and can change). This penalty structure is part of why 401(k) funds are generally considered less liquid than a typical taxable brokerage account.
After leaving an employer, 401(k) balances can typically be left in the former employer's plan (if allowed), rolled over into a new employer's plan, or rolled over into an IRA — each option has different considerations regarding investment choices, fees, and account consolidation.
Frequently Asked Questions
What happens to my 401(k) if I change jobs?+
Common options include leaving the funds in the former employer's plan (if permitted), rolling over to a new employer's 401(k), or rolling over into an IRA. Each has different implications for investment options and account management — this is a decision many people research at the time of a job change.
Is employer matching considered part of my contribution limit?+
Generally no — employee contribution limits and the combined employee-plus-employer limit are typically separate figures, with the combined limit being higher. Employer matching contributions count toward the combined limit but not toward the employee-only contribution limit. Specific figures change periodically, so checking current IRS limits is recommended.
Can I contribute to both a 401(k) and an IRA?+
In many cases, yes — though income limits may affect the tax deductibility of traditional IRA contributions (or eligibility for Roth IRA contributions) for those who also participate in an employer plan. This is covered further in the Roth vs. Traditional IRA lesson, and specific eligibility depends on individual circumstances.