401k Rules for Employees: What You Need to Know

A 401(k) is an employer-sponsored retirement savings account that allows employees to contribute a portion of their wages to individual accounts. Offered as a workplace benefit, these plans provide a tax-advantaged way to save for retirement, as contributions and earnings can grow tax-deferred or tax-free depending on the account type. Federal law, primarily the Employee Retirement Income Security Act of 1974 (ERISA), establishes the framework for these plans. The regulations govern how an employee can join a plan, how much can be saved, and when the employee gains full ownership of the funds.

Eligibility and Enrollment Rules

An employer can make its eligibility rules more lenient, but not stricter than what federal law requires. A company must allow an employee to participate if they have reached age 21 and completed one year of service. A year of service is a 12-month period during which the employee works at least 1,000 hours.

Recent changes in the law also created eligibility for certain long-term, part-time employees. These rules require employers to allow employees who have worked at least 500 hours per year for two consecutive years to make their own contributions. This change expands access to retirement savings.

The process of joining a plan happens through either automatic or voluntary enrollment. Many companies now use automatic enrollment, where eligible employees are signed up for the plan without taking any action. A default contribution rate is set by the employer, and funds are automatically deducted and invested. Employees are given notice and have the ability to opt-out, change their contribution rate, or alter their investment choices. Voluntary enrollment requires the employee to actively sign up by completing paperwork to begin contributions.

Contribution Rules and Limits

The Internal Revenue Service (IRS) sets annual limits on how much an employee can contribute to their 401(k) from their salary. For 2025, the maximum elective deferral limit is $23,000. This figure is subject to cost-of-living adjustments and applies to the total amount an employee contributes across all 401(k) plans they may have.

To help those closer to retirement, the tax code allows for catch-up contributions for employees age 50 and over. This provision permits these individuals to contribute an additional $7,500 for 2025. This means an employee age 50 or older could contribute a total of $30,500 for the year.

Contributions can be made as either Traditional or Roth. With a Traditional 401(k), contributions are made on a pre-tax basis, which reduces current taxable income. The investments grow tax-deferred, and withdrawals in retirement are taxed as ordinary income.

A Roth 401(k) operates differently. Contributions are made on a post-tax basis, meaning they are taken from pay after income taxes have been paid. Because taxes are paid upfront, qualified withdrawals in retirement are completely tax-free. This includes both the contributions and all the investment earnings. The choice between Traditional and Roth depends on an employee’s individual financial situation and their expectation of being in a higher or lower tax bracket in retirement.

Many employers also contribute to their employees’ 401(k) accounts. The most common form is an employer match, where a company might match 50% of every dollar an employee contributes up to the first 6% of their salary. Another type is a non-elective contribution, where the company contributes regardless of whether the employee does. The total from all sources cannot exceed a separate IRS limit, which for 2025 is $69,000, or 100% of compensation, whichever is less.

Understanding Vesting Rules

Vesting is the process of gaining full ownership of the money in your 401(k) account. Any money you contribute from your own salary, including investment earnings on that money, is always 100% yours immediately. The rules are different for employer contributions, such as matching funds or profit-sharing.

Employers can require you to work for a certain period to become fully vested in their contributions. Federal law dictates the maximum time an employer can make you wait, and there are two primary types of vesting schedules.

One method is cliff vesting. Under this schedule, an employee has zero ownership of employer contributions until they complete a specific period of service, at which point they become 100% vested. A cliff vesting schedule for employer matching contributions cannot be longer than two years.

The other method is graded vesting. This schedule allows an employee to gain ownership of employer funds incrementally over time. A graded schedule must provide at least 20% vesting after two years of service and must reach 100% vesting within six years. For example, a common schedule might give an employee 20% ownership after two years, 40% after three, and so on, until reaching 100% after six years of service. Your plan’s specific vesting schedule is in the Summary Plan Description (SPD) document from your employer.

Rules for Accessing Your Funds

When you leave an employer, you have several options for the money in your 401(k) account. You can roll the funds over into an IRA or into your new employer’s 401(k) plan, if permitted. You may also be able to leave the funds in your old employer’s plan, especially if the balance is over $7,000. Cashing out is a taxable event, and if you are under age 59.5, you will likely face a 10% early withdrawal penalty on top of regular income taxes.

It is sometimes possible to access 401(k) funds while still employed, though this is generally discouraged. Many plans allow for 401(k) loans. The IRS permits you to borrow up to 50% of your vested account balance, with a maximum loan amount of $50,000. These loans must be repaid within five years through payroll deductions. If you fail to repay the loan or leave your job, the outstanding balance is treated as a taxable distribution and may be subject to the 10% early withdrawal penalty.

Another way to access funds is through a hardship withdrawal, which does not have to be repaid. The IRS has strict rules defining what constitutes an immediate and heavy financial need, such as certain medical expenses, costs to purchase a principal residence, or payments to prevent eviction. Hardship withdrawals are subject to income tax and the 10% early withdrawal penalty if you are under age 59.5.

The primary purpose of a 401(k) is to provide income in retirement. Once you reach age 59.5, you can begin taking withdrawals without the early withdrawal penalty, though you will owe income tax on withdrawals from a traditional 401(k). The rules also mandate Required Minimum Distributions (RMDs), which currently must begin after you turn age 73.