What is a 401(k)?
A 401(k) is an employer-sponsored retirement savings plan that helps employees and business owners contribute to their retirement. If you work for a company that offers a 401(k) plan, you can contribute a portion of your paycheck into a retirement account. That money is then invested and can grow tax-free over time.
Key Takeaways:
- A 401(k) is an employer-sponsored retirement savings plan that helps employees and business owners contribute to their retirement. Employees contribute a select percentage or dollar amount to the 401(k), which is then invested.
- 401(k)s offer high contribution limits and no income restrictions compared to Individual Retirement Accounts (IRAs).
- 401(k) contributions are typically made on a pre-tax basis, allowing you to defer taxes until retirement. Many plans also offer a Roth 401(k) option, which lets you pay taxes now and enjoy tax-free withdrawals of both contributions and earnings in retirement.
- Most 401(k) withdrawals aren’t allowed until age 59½ and taking money out earlier can trigger taxes and penalties. While exceptions like the Rule of 55, in-service distributions, and required minimum distributions exist, eligibility and tax treatment depend on your age and your plan’s specific rules.
How Does a 401(k) Work?
401(k) Enrollment
If you have just been hired by a company that offers a 401(k), you’ll be asked to enroll in the 401(k) program. As a participant, or someone who is enrolled in a 401(k) plan, you cannot set up a 401(k) on your own. It must be sponsored by a company, unless you sponsor one yourself as a self-employed individual.
For some companies, 401(k) enrollment is immediately available; you’ll be able to enroll and contribute to the 401(k) plan at once. Other companies elect to have enrollment rules that dictate when an employee can enter into the 401(k).
Some rules include age or service requirements. For example, your company may need you to be over 21 years old and have 6 months of service. Some companies may choose to allow enrollment only during certain times of the year. It is all dependent on how the company’s 401(k) plan is set up.
Funding Your 401(k)
After you have enrolled in the 401(k), you will be asked to determine how much you want to contribute to your plan. Typically, the contribution amount is based on a percentage of your salary but can also be set to a certain dollar amount. Many financial advisors suggest saving 10-15%* of your income over your career for a comfortable retirement.
If you can’t quite start at 10%, then a great rule of thumb is to consider giving your 401(k) a raise. Each year when you get a raise at work, consider increasing your 401(k) contribution by 1%.
You can use ShareBuilder 401k’s online calculator to calculate how long your retirement savings will last based on your current deferral percentage. You can adjust the percentage and see just how saving 1% more may affect your retirement savings.
How Much Can You Contribute?
401(k)s a good choice for those who wish to start a retirement fund as they offer high contribution limits, especially when compared to IRAs.
| Under 50 Years Old | Age 50-59 or 64+ | Age 60-63 | |
|---|---|---|---|
| Employee 401(k) | $24,000 | $32,500 | $35,750 |
| Business Owner 401(k) | $72,000 | $80,000 | $83,250 |
| IRA | $7,500 | $8,600 | $8,600 |
Those under age 50 can contribute up to $24,500 with a 401(k), versus only $7,500 with an IRA. For those older than 50, catch-up contributions allow for an even higher contribution amount.
If you’re a self-employed business owner, you can contribute up to $72,000 (or more with catch-up contributions). This is because self-employed individuals can contribute both as an employee and employer.
With a 401(k), your income usually doesn’t affect whether you can contribute. You can save up to the annual contribution limit regardless of how much you earn. IRAs, however, do have income-based restrictions that limit how much you’re allowed to contribute or whether your contributions receive certain tax benefits.
401(k) Employer Matching
Your employer may decide to offer a 401(k) employer match for your plan. 401(k) employer matching is an amount the company contributes to the employee’s retirement account, typically matching a percentage of the employee’s own contributions. The most common employer match is a “dollar for dollar match.” That means that for every dollar you contribute to your 401(k) plan, your company will contribute that amount up to a certain percentage.
Say you make $75,000 and contribute 10% of your salary to your 401(k). You will contribute $7,500 annually to your retirement (not counting federal and state taxes). If your company offers a dollar for dollar match up to 4%, you will receive an additional $3,000 ($75,000 x 4%). That is essentially free money, or a bonus given to you by your company.
| Employer Match | Employee's Salary | Employee Contribution (10%) | Employer Contribution (Match) | Total Annual Contributions |
|---|---|---|---|---|
| 100%, or dollar for dollar, up to 4% | $75,000 | $7,500/year | $3,000/year | $10,500/year |
In this scenario, you’ll want to ensure that you are contributing at least 4% of your salary to your 401(k) plan, or you won’t be taking full advantage of the entire employer match.
Other common employer matching options include $0.50 on the dollar matching (or a 50% matching contribution), or even a fixed percentage that the employer automatically contributes on behalf of the employee, regardless of whether the employee makes their own contributions.
401(k) Investments
Once your money is deposited into your 401(k) account, it is invested with the goal of long-term growth. Depending on your plan’s 401(k) provider, you’ll be able to choose investments from a retirement-appropriate fund lineup or select from several model portfolios to build your nest egg.
Each pay period, your contributions are automatically invested. Your regular payroll contributions make use of an investing tactic called dollar-cost averaging. The money contributed to a 401(k) is invested with the goal of growing steadily and ultimately supporting your future retirement.
Pre-Tax vs Roth 401(k) Contributions
By default, when you enroll in a 401(k), your contributions are made on a pre-tax or tax-deferred basis, which means you pay taxes later—not today. Some 401(k)s also allow for Roth 401(k) contributions. Roth 401(k) contributions allow participants to make after-tax contributions to their 401(k) account. Once in retirement, these funds, earnings and all, aren’t taxed during withdrawal.**
When deciding between a tax-deferred 401(k) and a Roth 401(k), it’s important to consider your current tax rate and what you expect your tax rate to be in retirement.
Pre-Tax 401(k):
Contributing tax-deferred to your 401(k) will net you more tax savings in the current year, as these contributions reduce your current adjusted gross income. Taxes on both contributions and earnings are deferred until the funds are withdrawn in retirement, at which point they are taxed as ordinary income.
Roth 401(k):
Contributions are made with after-tax dollars, meaning they do not reduce your current taxable income. Because taxes are paid upfront, qualified withdrawals in retirement—including all earnings—are tax-free. Depending on whether your tax rate is higher now or in retirement, this approach may result in greater long-term tax savings.1
Ultimately, choosing between pre-tax and after-tax contributions comes down to whether you prefer to pay taxes now or later:
- If you prefer to pay taxes now or think your tax rate will be higher in retirement, contributing to your Roth 401(k) may be the better option.
- If you want to reduce your taxable income today or keep more of your current paycheck, a traditional 401(k) may be more advantageous.
- You can also choose to allocate a percentage of your salary to both. That way, you can receive some of the benefits of both retirement account types and diversify your tax exposure in retirement.
If you’re unsure about how to allocate your retirement contributions, consult with your tax advisor to determine what works for you.
Common 401(k) Plan Features
Automatic Enrollment
Automatic enrollment allows companies to sign up employees for the 401(k) plan automatically, meaning new hires are enrolled as of their start date. While employees can opt out, those who don’t are enrolled at a default contribution rate set by the company and will begin contributing that set percentage of their salary to the plan automatically.
Beginning with the 2025 plan year, 401(k) auto-enrollment is now required for new plans started after 12/29/22.
Automatic Escalation
Some companies may choose to include a 401(k) plan provision that automatically increases an employee’s deferral election on a regular basis. The most typical cadence is an annual 1% increase. Participants can also choose to opt-out of auto-escalation.
Beginning with the 2025 plan year, 401(k) auto-escalation is also required for new plans started after 12/29/22.
Vesting Schedules
Companies may impose vesting schedules for the employer-matched funds deposited into your 401(k). Vesting schedules determine when you officially "own" the employer contributions made to your 401(k) account. While the money you contribute is always 100% yours, the employer contributions may be subject to a vesting schedule. Here are the three common types of vesting schedules:
| Vesting Type | Definition |
|---|---|
| Immediate Vesting | You own 100% of the employer contributions right away. |
| Cliff Vesting | You become 100% vested all at once after a specific period (often 1 to 3 years). |
| Graded Vesting | You become vested gradually over time, typically over a 3–6 year period. If you leave your job before you're fully vested, you may forfeit some or all of the employer matching contributions. |
Understanding your vesting schedule helps you plan your career moves and retirement savings strategy.
401(k) Withdrawal Rules
When Can You Make a Withdrawal?
401(k)s are meant to be a retirement vehicle, so there are strict rules on when and how you’re able to withdraw your money. Generally, you must wait until age 59½ to make a distribution (i.e. take money out of your account). If you make a withdrawal earlier, you’ll most likely owe a 10% tax penalty on top of income tax for pre-tax contributions.
Some exceptions include:
- You become permanently disabled
- You leave your job at age 55 or older (Rule of 55)
- You need funds for qualified medical expenses when your unreimbursed costs exceed 7.5% of your adjusted gross income, and you do not itemize your tax deductions
These exceptions fall under in-service distributions, and their availability can vary depending on your 401(k) plan. Check with your plan administrator to determine if they are an available option.
Rule of 55
The 401(k) Rule of 55 lets you take penalty-free withdrawals from your 401(k) if you leave your job in or after the year you turn 55 (or age 50 for certain public safety workers). The Rule of 55 only applies after you have left your job, not while you are still working.
Some items to keep in mind:
- Your specific 401(k) plan must allow early withdrawals
- Applies only to the 401(k) at the job you just left—not previous plans or IRAs
- Regular income taxes still apply, but the 10% early withdrawal penalty is waived
- You must leave your job in the calendar year you turn 55 or later (50 for public safety roles)
- You can take only what you need and can take multiple withdrawals over time, not just a one-time lump sum
401(k) In-Service Distributions
In-service distributions allow you to withdraw money from your 401(k) while you’re still employed by the company sponsoring the plan. Once you reach age 59½, you can typically take distributions from vested employer contributions without incurring an early withdrawal penalty.
Availability and eligibility depend on your plan’s specific rules, so in-service distributions may not always be an option.
Required Minimum Distributions
Required Minimum Distributions (RMDs) are mandatory withdrawals you must begin taking from your 401(k) once you reach a certain age. The IRS sets the starting age at which you’re required to withdraw each year. The amount is calculated by dividing the balance of your retirement account on December 31 of the previous year by a number called your life expectancy factor, which is provided in IRS tables.
Failing to take RMDs on time can result in significant tax penalties, so it’s important to understand when they apply and how much you need to withdraw.
What Happens to a 401(k) When You Switch Jobs?
If your 401(k) plan has $7,000 or more in assets, you can typically leave the account where it is when you leave your job. If your current 401(k) has a decent line-up of funds and low fees, this could be a good option.
However, it’s common for departing employees to move or “rollover” their 401(k) monies into another retirement account, such as an IRA or the 401(k) of their new employer. Not only does it make administration easier, as all 401(k) monies are in the same account, but you can adjust investment allocations for your entire balance and see your rate of return. Just make sure to consider whether the investment expenses are the same or lower and if the provider offers investment funds you need or prefer.
It is wise to leave your 401(k) assets in a retirement investment account, as cashing out your 401(k) and taking a lump sum distribution would result in taxation on the entire amount. If you’re under age 59½, you would also have to pay early withdrawal penalties as well. Rolling over your 401(k) assets is typically the best choice, as it is also more difficult to reinvest the money you cashed out since 401(k)s and IRAs have annual contribution limits.
FAQs
What is a 401(k)?
A 401(k) is an employer-sponsored retirement savings plan that allows employees and business owners to contribute a portion of their income toward retirement. Contributions are invested and grow over time, often with tax advantages such as tax-deferred or tax-free growth, depending on the type of 401(k).
Why is it called 401(k)?
It’s called 401(k) because the plan is defined under Section 401, paragraph (k) of the U.S. Internal Revenue Code. This section outlines the rules governing cash or deferred arrangements that allow employees to defer a portion of their compensation into retirement savings.
How does a 401(k) work?
A 401(k) works by allowing employees to contribute a percentage or dollar amount from each paycheck into a retirement account. Those contributions are invested in funds selected by the participants.
What's the difference between a pre-tax 401(k) and a Roth 401(k)?
Pre-tax (tax-deferred) contributions can reduce your taxable income today, but withdrawals in retirement are taxed. A Roth 401(k) uses after-tax contributions, meaning you pay taxes now, but qualified withdrawals in retirement—including earnings—are tax-free. Choosing between them depends on whether you expect your tax rate to be higher now or in retirement.
*Industry experts generally agree that, depending on when you begin contributing, a minimum contribution of 10-15%, will be necessary to reach a goal of 8 to 10 times your ending annual salary prior to retirement. You may want to review your current contribution level to determine whether you believe it is sufficient to meet your retirement goals. There is no guarantee that contributions at this level will result in sufficient funds to meet those goals.
**Withdrawals before the age of 59 1/2 may incur a 10% tax penalty.
1ShareBuilder 401k does not offer tax or legal advice. Consult with your tax or legal advisor before engaging in specific strategies.