Guide to 401(k) Plans

What is a 401(k)?

A 401(k) plan is a retirement savings plan sponsored by an employer that allows employees to save and invest for their future. It’s named after the subsection 401(k) of the U.S. Internal Revenue Code.

Most full-time jobs offer one. Most people contribute the wrong amount to it — usually because nobody walked them through how it actually works. This guide does that.

How a 401(k) actually works

• Employer-sponsored. These plans are offered by companies to their employees.
• Defined contribution. Your retirement benefit depends on how much you and your employer contribute and what those investments earn — unlike an old-school pension, where the benefit is predetermined.
• Salary deferral. You can choose to contribute a portion of your paycheck before taxes are taken out (in a traditional 401(k)). That reduces your taxable income for the year.

Traditional vs. Roth

Traditional 401(k)

• Contributions are made pre-tax: the money is deducted from your paycheck before income tax.
• Your taxable income drops in the year you contribute.
• Investment earnings grow tax-deferred.
• Withdrawals in retirement are taxed as ordinary income.

Roth 401(k)

• Contributions are made after-tax: you pay income tax on the money before it goes in.
• Your taxable income is not reduced in the year you contribute.
• Investment earnings grow tax-free.
• Qualified withdrawals in retirement (after age 59½, with the account open at least five years) are tax-free.

2026 contribution limits

The IRS sets annual limits on how much you can contribute to a 401(k). These are the maximums — you can always contribute less.

Employer matching

Many employers offer to match a portion of your contributions. A common formula: 50% match on the first 6% of your gross salary you contribute. Employer matching is essentially free money and can significantly boost your retirement savings over time.

A note on percentages: gross, not net

When your HR portal asks “what percent do you want to contribute?”, that percentage runs against your gross paycheck — the full amount you earned before taxes, FICA, and any other deductions. It does not run against your take-home pay.

A typical example: you earn $5,000 gross per pay period and elect a 10% deferral. Payroll deducts $500 (10% × gross) into the 401(k), then computes income tax and FICA on the remaining $4,500, then deducts your health insurance premium and anything else, and what’s left lands in your bank as take-home. Your employer match is calculated the same way — against the gross.

This is why the order of operations anchors “15% to retirement” against gross income. Anchoring on take-home would silently undersave by ~30%, since taxes and deductions can eat that much off the top.

Tax advantages

Tax-deferred growth (Traditional): your money grows without being taxed each year — you only pay taxes when you withdraw in retirement.

Tax-free growth (Roth): your money grows tax-free, and qualified withdrawals in retirement are also tax-free.

Reduced taxable income (Traditional): contributions lower your current taxable income, potentially saving you money on this year’s taxes.

What you can invest in

Within a 401(k) plan, you typically have a range of investment options:

• Mutual funds — pooled investments across many stocks or bonds. Index funds and target-date funds are common.
• Exchange-traded funds (ETFs) — similar to mutual funds, often with lower fees.
• Individual stocks and bonds — less common, and usually not recommended for beginners.

Getting your money out

1. Early withdrawals (before age 59½) are generally hit with a 10% penalty plus regular income taxes. Some hardship exceptions exist.
2. Withdrawals in retirement are taxed as ordinary income for traditional 401(k)s. Qualified Roth withdrawals are tax-free.
3. Required Minimum Distributions (RMDs) kick in for traditional 401(k)s, currently at age 73 (rising to 75 in 2032 under SECURE 2.0). Roth 401(k)s no longer have RMDs.

What happens when you switch jobs

If you leave your employer, you generally have a few options:

• Leave it with your former employer’s plan (if the balance is over a certain threshold).
• Roll it into your new employer’s 401(k).
• Roll it into an Individual Retirement Account (IRA) — see our guide to IRAs.
• Cash it out — generally not recommended due to taxes and penalties.

Key takeaways

A 401(k) is a powerful retirement tool because of its tax advantages and the potential for employer matching. The short version:

• If your employer matches, contribute enough to get the full match.
• Pick traditional or Roth based on whether your tax bracket is likely to be higher now or in retirement.
• Pay attention to fees — small differences compound over decades.
• Don’t make impulsive changes based on short-term market moves.